It is now 5 years since the beginning of the global financial crisis and it is interesting to reflect on how the processes of credit risk analysis eventually impacted the global economy. The subprime mortgage crisis in the United States was the beginning of a chain events that had a domino type effect where the financial viability of some of the largest financial institutions was downgraded which led to a collapse in the stock market and eventually to a national recession with rising unemployment, lowered tax revenues and indeed a global recession as the economies of the rest of the world were impacted by the events in the United States.
The catalyst for what eventually turned into a catastrophe was a set of complex financial instruments which essentially enabled banks to sell the risk of credit default to other players in the economy. In the times when financial institutions placed more emphasis on the credit rating of the consumers applying for their products, the buyers of these instruments which were called collateralised debt obligations could comfortably make a profit on the transaction because the credit risk associated with their purchase of the rights to these loans was low enough such that they could profit from the transaction despite lending to the occasional credit defaulter.
However, this led to a behaviour in the banks where they had little or no regard for the credit history of consumers applying for loans. Over time, there was no correction for the risk of credit default factored into these securitisation transactions and both banks and securitisation companies were left without any loans which could be relied upon for repayment. This obviously undermined the financial viability of the banks.
To make matters worse, the banks which had not engaged in this practice of securitisation and were considered to be more financially sound had often lent money to second tier banks and were therefore exposed to these credit rating problems as they began to snowball into one of the worst financial crises in living memory.
Although it may seem inconspicuous, when someone applies for a loan or a credit card they are actually engaging a process of analysis undertaken by the banks to try to ensure that credit risk does not at a later state undermine the viability of the company. In the time since the global financial crisis, the lending criteria have been substantially restricted so that only borrowers with high levels of credit reliability can access the best market rates in the industry.
