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In order to assess and manage credit risk and to minimize the risk of default on an individual advance (credit), banks can, as a first step, consider what loaned funds are intended to be used for (or what they are being used for) and other financial circumstances of the borrower. Credit scoring is playing an increasingly prominent role in selecting good risks in consumer lending. A potential borrower (applicant) is asked a standard set of questions relating to factors such as age, assets held, financial commitments, and so on; and, based on the answers, a score is calculated reflecting the credit risk of the applicant.
Consider the foregoing statement. Explain the method of credit scoring. Discuss various ways in which credit scoring could be employed by commercial and retail banks in order to reduce the incidence of loan defaults. Critically evaluate the effectiveness and robustness of this method as a credit risk management technique.
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