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Describe Credit ratings Essay

Because credit card companies and banks must charge the same interest rate on credit cards to all borrowers, there is an adverse selection problem with credit cards. How does a credit company or firm know whether a person will be a high-quality borrower (i. e. , one who pays the debts) or a low quality borrower (i. e. , one who does not pay debts)? Describe Credit ratings are usually used in determining the whether or not a person will be a high quality borrower or not.

In coming up with this decision, many factors are considered. One method of differentiating between the high-quality borrowers and the low-quality borrowers is by using a FICO rating. This is named after Fair Isaac & Co. , the firm that developed the scoring model used by the three major credit bureaus – Equifax, Experian and Trans Union. FICO scores range from about 300 to 900. Generally, the higher the score of the economic agent or borrower, the lower is its credit risk.

It is very difficult to say what a “good” or “bad” score is, though, since lenders have different standards for how much risk they will accept. Generally, the use of these and similar

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rating systems will provide credit card companies with the basic information that they need in order to make their decision. High-quality borrowers would generally be the ones with no large sums of outstanding debts and who have also been prompt in meeting their payments.

These people are not necessarily asset rich but are financially liquid or flexible enough to meet the payments as they fall due. Low-quality borrowers, on the other hand, would be those with a bad credit history. This usually means that these types of borrowers have either had past due accounts with several financial institutions or have opened several credit accounts in a relatively short period of time. It is also important to note that another important criterion for low-quality borrowers has to do with the type of credit exposure that they have.

This indicates the level of leverage that a person or institution has with banks and the like. a) How the restriction of a single rate leads to an adverse selection problem The restriction of a single rate leads to an adverse selection problem because it does not discriminate. In the highly lucrative world of credit card financing, a company is tied down by the legal restrictions on the amount of interest that can be imposed. Certain countries have usury laws that prevent the imposition of interest rates above a predetermined level.

Companies are also not allowed to have separate rates for separate credit card holders. The implication of this is simply that without the different rates the exposure of a bank to a potential low-quality borrower is equally high. To illustrate, if A is a high-quality borrower, the single rate does not necessarily work in his favor because he meets the payments on time and does not necessarily incur interest. The few times that it may happen, however, does not cause any concern for the credit card company.

If A were a low-quality borrower, the bank is exposed to more risk but since a different rate cannot be applied the exposure will only grow as the payments continue to be unsatisfied. The adverse selection problem that comes in therefore is that the interest rates do not quite cover the financial exposure caused by a low-quality borrower. b) At least two potential means that credit card companies can use to try to lessen this problem.

As previously mentioned, banks and credit card companies use a variety of methods to differentiate between high-quality borrowers and low-quality borrowers. One method that can be used to lessen this problem is by coming up with an accurate way of predicting who the liabilities or risks are. Another method would be what banks usually use in assessing the credit worthiness of a borrower which is the Multivariate Discriminant Analysis (MDA). This method, which helps the credit officer quickly and efficiently, assesses the credit worthiness of a potential debtor.

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