In an ideal world, everyone would have enough money to take care of their needs. However, in reality, most of us need to borrow money to meet our needs and life goals. There are many places that you can borrow from: friends, family members, street shark loaners, street lenders, and banks. The majority of people depend on banks when they want to borrow. Whenever you apply for a loan from a bank, your credit rating is checked. Banks and financial institutions are using credit rating agencies to check your credit rating. A credit rating agency is an organization that evaluates the creditworthiness of an individual or company who wishes to borrow money or apply for a line of credit in the bank. You might ask yourself what is a credit rating? A credit rating is an assessment of the borrower that determines whether the borrower will be able to pay the loan/credit on time, as per the loan agreement. Needless to say, a good credit rating depicts a good history of paying loans on time in the past. This credit rating influences the bank’s decision of approving your loan application at a considerate rate of interest.
In Tanzania, we have only two credit rating agencies which I believe are too few to serve more than 50+ commercial banks that we currently have: CreditInfo Tanzania and Dun & Bradstreet. Credit rating agencies are known as Credit Reference Bureaus. Credit rating agencies in Tanzania started in 2013, only seven years ago with Creditinfo Tanzania starting in June 2013 as the first licensed and operational credit reference bureau in Tanzania. I believe that to improve the performance of the banking sector, stimulate economic development, and address the problem of information asymmetries, we need more than two credit rating agencies in the country. Therefore, the banks and financial instructions regulator needs to do more to improve the business environment for credit bureaus to operate and attract more credit rating agencies in the country.
At the consumer level, the agency’s ratings are used by banks to determine the risk premium to be charged on loans. A poor credit rating shows that the loan has a higher risk premium, and this prompts an increase in the interest charged to individuals and entities with a low credit rating. A good credit rating allows borrowers to easily borrow money from the bank at a lower interest rate. Meanwhile, at the corporate level, companies planning to issue debt security must find a rating agency to rate their debt or the companies who want to borrow, must have at least an acceptable credit rating to be approved. Having effective credit rating agencies is vital for the health of the banking and financial industry, as they assess the creditworthiness of governments, corporations, banks and other entities that wish to raise funds by issuing debt. There are many benefits of having effective credit rating agencies to both banks, consumers and the state of the country’s economy. In this article, I will share a few:
- Better Investment Decision for Banks — It is worth noting that no bank would like to give money to a risky customer. With the credit rating, the bank gets an idea about the creditworthiness of the borrower (an individual or company) and the risk factor attached to them. By evaluating credit rating reports, a bank can make a better lending decision. In addition, credit ratings enable the bank to save time and effort in analyzing the financial strength of a borrower. This is because the bank can depend on credit rating reports done by a credit agency when making a lending decision. Like any human situation, the credit rating agencies cannot be said to be perfect so it is very important to point out that a bank shouldn’t depend 100% on the credit rating report. The bank should maintain its internal process and procedures and do its due diligence when it’s making a lending decision. However, the credit rating report helps to simplify the job for the bank.
- Efficiency in the Credit Markets — Credit rating agencies improve efficiency and transparency in the credit market by helping to reduce the knowledge gap between borrowers and lenders (banks). The knowledge gap I am referring to is the borrower’s creditworthiness. Although the lender may be able to correctly characterize potential borrowers most of the time, there is still a chance of misjudging the borrower or internal staff colluding with the borrower to issue unwarranted loans, so by combining credit ratings and the bank’s analysis, the bank can determine more accurately the creditworthiness of the borrower. Usage of multiple approaches (internal analysis and credit bureau agencies), will enable the bank to be more confident about their lending decisions hence the banks will be able to set up loan interest rates that truly reflect the riskiness of the borrower. And this should ensure superior allocation of the limited credit which results in more net profits for the banks.
- Determination of Interest Rate — Every bank offers a loan at a particular range of interest rate based on the market’s conditions and subject to changes in line with money market conditions. One of the major factors that determine the rate of interest on a loan is the credit history of a borrower which is obtained through a credit rating report. The higher the credit rating of a borrower, the lower the loan’s interest rate for the borrower. The interest rate on the loan is very important to the borrower since it has a big impact on the cost the borrower is paying for borrowing the money (loan). A lower interest rate on a loan is easier to repay than a higher interest rate because there is less interest added on top of the loan amount.
To summarize, I shared that banks and financial institutions are using credit rating agencies to check the credit ratings of loan applicants (potential borrowers) to determine their creditworthiness. With the credit rating, the bank gets an idea about the creditworthiness of an individual or company (borrower) and the risk factor attached to them, hence enabling a bank to make a better lending decision. Also, we have seen other benefits of having effective credit rating agencies for both the banks (financial institutions) and consumers. Credit rating agencies improve efficiency and transparency in the credit markets by helping to reduce the knowledge gap between borrowers and lenders (banks) and helps to promote fairness in lending by playing a huge role in determining the correct interest rate charged on loans.
Written by Kelvin Mkwawa, MBA
Email address: Kelvin.firstname.lastname@example.org
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