Identify and define the borrower-specific and market-specific factors that enter into the credit decision. What is the impact of each type of factor on the risk premium?
The borrower-specific factors are:
Reputation: Based on the lending history of the borrower; better reputation implies a lower risk premium.
Leverage: A measure of the existing debt of the borrower; the larger the debt, the higher the risk premium.
Volatility of earnings: The more stable the earnings, the lower the risk premium.
Collateral: If collateral is offered, the risk premium is lower.
Market-specific factors include:
Business cycle: Lenders are less likely to lend if a recession is forecasted.
Level of interest rates: A higher level of interest rates may lead to higher default rates, so lenders are more reluctant to lend under such conditions.
a. Which of these factors is more likely to adversely affect small businesses rather than large businesses in the credit assessment process by lenders?
b. How does the existence of a high debt ratio typically affect the risk of the borrower?
c. Why is the volatility of the earnings stream of a borrower important to a lender?