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A default model is a means of evaluating creditworthiness and the potential for default. While credit scoring is commonly used when evaluating individuals and small businesses for loans and lines of credit, lenders usually make use of a default model when considering the extension of some form of credit to a corporation. There are a number of different types of models that may be used, with most structured to consider variables such as industry type, current debt load, and the future prospects of the borrower.
The main purpose of the default model is to determine the level of risk that the creditor will assume in order to do business with the applicant. Part of this process requires careful evaluation of all basic criteria to determine what is known as the default probability of the borrower. This is essentially the amount of potential that exists for the applicant to eventually default on the provisions associated with the loan or credit contract.
While the variables considered in a given default model may be slightly different from one situation to the next, there are a few core strategies that are employed with most models. One has to do with the use of what is known as regression analysis. This is simply the process of looking at each variable that is considered as part of the model, identifying possible changes to that variable, and then projecting how those changes would affect the ability of the borrower to honor the covenants associated with the debt obligation. As part of the process, the probability of that particular change occurring is also taken into consideration.
Use of a default model is normally utilized when a large corporation presents the loan or credit application. Since the amount of the loan is likely to be somewhat larger than the typical loans requested by individuals or small businesses, the lender is likely to scrutinize the financial condition of the borrower in greater detail. This is necessary in order to determine if the level of credit risk assumed by the lender is within a reasonable range, based on the amount requested in the loan application. Along with assessing the current financial circumstances of the applicant, a lender will also consider the general state of the economy, the place of the applicant within a given industry, and the projected future of that industry. Should the lender determine that approving the application presents a relatively low degree or risk, and that market conditions are likely to remain stable for the duration of the loan, there is a good chance that the application will be approved.