Unit 03 · Chapter 2 · 10 min read

Credit risk and repayment capacity

Separate willingness, ability, exposure, and loss severity.

A borrower can have a real identity, an honest intention, and no money when the payment is due. Credit risk is the gap between a promise and the ability to keep it. Fraud controls help, but they do not replace repayment analysis.

Separate default probability and loss severity

Probability of default estimates the chance that a defined default event occurs over a defined horizon. Loss given default estimates the loss fraction if default occurs. Exposure at default estimates the amount at risk then. A simple expected-loss model multiplies these quantities.

State the default definition and horizon before comparing estimates. A missed payment, a thirty-day delinquency, and a charged-off account are different events. In a teaching example, 4 percent probability, 50 percent loss severity, and $10,000 exposure imply $200 expected loss. This simplified result excludes timing, uncertainty, and other accounting or capital requirements.

Probability of default, loss given default, and exposure at default describe different uncertainties. A borrower can have a modest chance of default but create a large loss if there is little usable recovery. Another can default more often while producing lower losses because exposure is smaller or recoveries are stronger. The simplified product PD × LGD × EAD is an expected value over stated assumptions, not a complete accounting standard or a description of the worst case.

These quantities can also move together under stress. A downturn may increase defaults at the same time that collateral loses value and customers draw unused commitments. Treating each input as an independent fixed average can understate the combined event. A stress case should explain how the shared cause affects all relevant components.

Separate default probability and loss severity Separate default probability and loss severity — the flow Follow the sequence. Estimate exposure when default occurs. PD Define event probability and horizon LGD Estimate conditional loss fraction EAD Estimate exposure when default occurs — Follow the sequence. Estimate exposure when default occurs. Chapter sources · Open image

Separate default probability and loss severity Separate default probability and loss severity — the distinction These concepts answer different questions. Read each definition in the context of the section. High default probability Default is more likely High loss severity More is lost if default occurs — These concepts answer different questions. Read each definition in the context of the section. Chapter sources · Open image

Separate default probability and loss severity Expected-loss example Fictional teaching record. Expected loss is 200 USD. Expected-loss example Illustrative data; not a real customer record or a prescribed policy. PD 4 percent 0.04 probability LGD 50 percent 0.50 loss fraction EAD 10000 USD Expected loss is 200 USD Each changes expected loss differently — Fictional teaching record. Expected loss is 200 USD. Chapter sources · Open image

Separate default probability and loss severity Separate default probability and loss severity — control and failure modes Each changes expected loss differently. The branches show why alternative designs fail. Control design Keep probability severity and exposure separate. Each changes expected loss differently. Failure mode 1 Use delinquency rate as severity. They measure different things. avoid Failure mode 2 Compare horizons without adjustment. One month and one year are not equivalent. avoid Failure mode 3 Call expected loss a guaranteed loss. Actual outcomes vary. avoid — Each changes expected loss differently. The branches show why alternative designs fail. Chapter sources · Open image

Assess cash available for repayment

Revenue is not cash available for debt service. Operating costs, taxes, existing obligations, working-capital needs, and timing all affect repayment capacity. Use a consistent period and distinguish recurring inflows from one-time transfers.

A business with $100,000 monthly receipts and $85,000 essential outflows has $15,000 before the proposed debt payment under these simplified assumptions. A $12,000 payment leaves a narrow $3,000 margin. Test sensitivity to lower sales or delayed receipts. The decision should reflect the actual product terms and verified evidence, not only a favorable average month.

Assess cash available for repayment Assess cash available for repayment — the flow Follow the sequence. Assess the remaining payment margin. Inflows Identify recurring usable receipts Outflows Include essential obligations Capacity Assess the remaining payment margin — Follow the sequence. Assess the remaining payment margin. Chapter sources · Open image

Assess cash available for repayment Assess cash available for repayment — the distinction These concepts answer different questions. Read each definition in the context of the section. Gross receipts Money entering the account Repayment capacity Funds left after relevant obligations — These concepts answer different questions. Read each definition in the context of the section. Chapter sources · Open image

Assess cash available for repayment Monthly capacity example Fictional teaching record. Leaves 3000 USD margin. Monthly capacity example Illustrative data; not a real customer record or a prescribed policy. Receipts 100000 USD Assumed recurring inflows Essential outflows 85000 USD Before proposed debt New payment 12000 USD Leaves 3000 USD margin Receipts alone overstate available capacity — Fictional teaching record. Leaves 3000 USD margin. Chapter sources · Open image

Assess cash available for repayment Assess cash available for repayment — control and failure modes Receipts alone overstate available capacity. The branches show why alternative designs fail. Control design Analyze remaining cash and timing. Receipts alone overstate available capacity. Failure mode 1 Treat all revenue as disposable cash. Costs and obligations remain. avoid Failure mode 2 Ignore existing debt. It competes for the same cash. avoid Failure mode 3 Use a one-time transfer as recurring income. That inflates expected capacity. avoid — Receipts alone overstate available capacity. The branches show why alternative designs fail. Chapter sources · Open image

Distinguish fraud and credit evidence

False income documents concern deception. A genuine income decline concerns capacity. Both can lead to nonpayment but require different controls and customer responses. Keep the reason for a credit decision specific to the evidence and applicable requirements.

Use identity and document checks to establish trustworthy inputs, then assess repayment with those inputs. A high identity confidence score does not mean low default probability. Conversely, a borrower with limited credit history is not necessarily using a false identity. Avoid a single opaque risk label that mixes fraud, affordability, and legal eligibility.

Distinguish fraud and credit evidence Distinguish fraud and credit evidence — the flow Follow the sequence. Record the actual decision factors. Validate inputs Test identity and document claims Assess capacity Evaluate repayment evidence Explain Record the actual decision factors — Follow the sequence. Record the actual decision factors. Chapter sources · Open image

Distinguish fraud and credit evidence Distinguish fraud and credit evidence — the distinction These concepts answer different questions. Read each definition in the context of the section. Document deception Input may be false Income volatility Input may be true but unstable — These concepts answer different questions. Read each definition in the context of the section. Chapter sources · Open image

Distinguish fraud and credit evidence Borrower evidence Fictional teaching record. Specific assessed factor. Borrower evidence Illustrative data; not a real customer record or a prescribed policy. Identity verified Person claim supported Income seasonal Capacity varies Decision reason insufficient stable cash Specific assessed factor They address different uncertainties — Fictional teaching record. Specific assessed factor. Chapter sources · Open image

Distinguish fraud and credit evidence Distinguish fraud and credit evidence — control and failure modes They address different uncertainties. The branches show why alternative designs fail. Control design Separate input trust from repayment capacity. They address different uncertainties. Failure mode 1 Approve credit from identity score alone. Identity does not establish ability to pay. avoid Failure mode 2 Treat thin history as identity theft. The evidence does not support that conclusion. avoid Failure mode 3 Use a generic risk reason for everything. It obscures the real basis. avoid — They address different uncertainties. The branches show why alternative designs fail. Chapter sources · Open image

Model terms and behavior together

A limit, payment schedule, maturity, and pricing structure affect exposure and customer behavior. A larger revolving limit can increase future drawn exposure even if today’s balance is small. A short repayment cycle can strain a seasonal business.

Evaluate the proposed terms as part of the decision, not as an afterthought. Use scenarios for utilization, repayment, and stress. Distinguish an approved limit from a funded balance and from projected exposure at default. The three may differ substantially. Reassess terms through an approved process when the underlying evidence changes.

Loan terms change borrower behavior and the platform’s exposure. A shorter repayment period may reduce time at risk while increasing the payment burden. A larger limit may improve the customer’s flexibility while increasing the amount outstanding when conditions worsen. Model and policy reviews should therefore consider the offered terms, not just whether an applicant receives a binary approval. A decision record is stronger when it explains both eligibility and the particular amount, duration, or conditions offered.

Model terms and behavior together Model terms and behavior together — the flow Follow the sequence. Project the amount at risk. Terms Define limit timing and repayment Behavior Estimate use under those terms Exposure Project the amount at risk — Follow the sequence. Project the amount at risk. Chapter sources · Open image

Model terms and behavior together Model terms and behavior together — the distinction These concepts answer different questions. Read each definition in the context of the section. Approved limit Maximum permitted availability Drawn balance Current amount already used — These concepts answer different questions. Read each definition in the context of the section. Chapter sources · Open image

Model terms and behavior together Revolving-line example Fictional teaching record. Illustrative future scenario. Revolving-line example Illustrative data; not a real customer record or a prescribed policy. Limit 20000 USD Potential availability Drawn now 5000 USD Current balance Stress draw 15000 USD Illustrative future scenario Current balance may understate later exposure — Fictional teaching record. Illustrative future scenario. Chapter sources · Open image

Model terms and behavior together Model terms and behavior together — control and failure modes Current balance may understate later exposure. The branches show why alternative designs fail. Control design Model future utilization under the proposed terms. Current balance may understate later exposure. Failure mode 1 Use the full limit as current cash debt. Availability and use differ. avoid Failure mode 2 Ignore repayment timing. Capacity depends on when money is due. avoid Failure mode 3 Assume behavior never responds to terms. Limits and schedules influence use. avoid — Current balance may understate later exposure. The branches show why alternative designs fail. Chapter sources · Open image

Preserve a reasoned decision record

Record the application state, evidence, model and policy versions, decision, and actual reasons. Credit decisions can carry notice and record duties that vary by product and applicant. The implementation must map those duties to the correct lifecycle event.

A technical explanation is not automatically a compliant customer explanation. A model feature may need translation into a specific, accurate reason through an approved process. Keep that translation versioned and test it against actual decisions. Do not invent a convenient reason after the fact because the model cannot explain itself.

Preserve a reasoned decision record Preserve a reasoned decision record — the flow Follow the sequence. Preserve the required decision history. Decide Use recorded evidence and policy Explain Map actual factors to approved reasons Retain Preserve the required decision history — Follow the sequence. Preserve the required decision history. Chapter sources · Open image

Preserve a reasoned decision record Preserve a reasoned decision record — the distinction These concepts answer different questions. Read each definition in the context of the section. Model attribution Technical contribution estimate Decision reason Actual basis expressed appropriately — These concepts answer different questions. Read each definition in the context of the section. Chapter sources · Open image

Preserve a reasoned decision record Credit decision record Fictional teaching record. Apply the relevant duty. Credit decision record Illustrative data; not a real customer record or a prescribed policy. Policy credit-v12 Reproducible rule set Factor verified cash shortfall Actual assessed basis Notice route product-specific Apply the relevant duty The explanation must reflect what actually drove it — Fictional teaching record. Apply the relevant duty. Chapter sources · Open image

Preserve a reasoned decision record Preserve a reasoned decision record — control and failure modes The explanation must reflect what actually drove it. The branches show why alternative designs fail. Control design Use accurate reasons tied to the decision. The explanation must reflect what actually drove it. Failure mode 1 Invent a generic reason afterward. That breaks the evidence chain. avoid Failure mode 2 Assume feature importance is always sufficient. Technical attribution needs appropriate interpretation. avoid Failure mode 3 Apply one notice rule to all products. Scope and requirements can differ. avoid — The explanation must reflect what actually drove it. The branches show why alternative designs fail. Chapter sources · Open image

Chapter connections

This chapter builds on Underwrite the merchant business. Continue with Cash-flow analysis and financial evidence to follow the next part of the system. Use the glossary for terminology and risk mathematics for formulas and worked calculations.

Sources

Reviewed 2026-09-17