Transcription of http://www.nber.org/chapters/c4732.pdf
1 This PDF is a selection from an out-of-print volume from the NationalBureau of Economic ResearchVolume Title: Commercial Banks and Consumer Instalment CreditVolume Author/Editor: John M. Chapman and associatesVolume Publisher: NBERV olume ISBN: 0-870-14462-6 Volume URL: Date: 1940 Chapter Title: Factors Affecting Credit Risk in Personal LendingChapter Author: John M. ChapmanChapter URL: pages in book: (p. 109 - 139)5 FactorsAffecting Credit Risk inPersonal LendingTHE credit standing of an applicant for a personal loan isinvestigated intensively because it indicates, within reason-able limits, the likelihood of repayment.
2 It should not beassumed, however, that a bank officer can foretell with cer-tainty how faithfully a borrower will meet his obligations;few applicants have economic prospects so bad that there isnot some small chance of repayment, and few are so well sit-uated that there is not some possibility of delinquency oreven default. The selection of borrowers must therefore reston probabilities. On the basis of experience, and to some ex-tent intuition, the loan officer decides which applicants aremore likely to default than others or which loans are likelyto involve collection costs so great as to render the and ability of the borrower to repay the loanare the primary factors to be considered in any appraisal ofcredit risks.
3 Applicants who may be attempting fraud areclearly undesirable, as are those who, though not strictly dis-honest, may appear to be irresponsible. The second criterion,ability to repay, may be tested by several standards: by per-sonal characteristics such as age, sex and family status; andby the borrower's occupational or economic position, incomeand net general, then, the bank is interested in the moral, per-sonal, vocational and financial characteristics of the applicantfor a personal loan. The would-be borrower is asked to109110 BANKS AND INSTALMENT CREDIT supply credit references, banking connections and informa-tion concerning his charge accounts, since these give someevidence of his probity.
4 Age, sex, marital status, number ofdependents and permanence of residence, are pertinent per-sonal characteristics. The nature of the applicant's occupation,his tenure of employment, and the industry in which he is en-gaged are clues to his ability to pay. His income, assets (realestate,, household goods, automobiles, stocks and bonds) anddebts (mortgages, charge accounts and instalment accounts)serve to indicate his financial capacity. These characteristicsare all, of course, interrelated. Personal traits affect, and arein turn affected by, an applicant's occupation and earningpower.
5 A balanced income-expenditure relationship, or asubstantial net worth, reflects not oniy the borrower's finan-cial capacity but also his prudence and f resight in the man-agement of his following pages are devoted to a statistical analysis ofthe principal factors affecting credit risk. The informationon which the study is based was obtained from a sample of2,765 applications of persons to whom loans were data, secured through the cooperation of 21 large banksoperating personal loan departments in 16 cities situated inii states,1 are presented in a series of tables giving the distri-butions of good and of bad loans according to the several riskfactors selected.
6 The information covering this group of bor-rowers pertains only to their financial, personal and voca-tional characteristics. No direct information was requestedon past payment record, legal actions or the quality of refer-ences given, and consequently the analysis provides no ade-The cooperating banks were asked to provide random samples of good andbad loans. Good loans were defined as those which paid out without anyspecial collection difficulty and bad loans as those which either were excessivelydelinquent or ended in de(ault. The drawing of the samples was subject toonly two conditions: (1) that the loans in both samples were made within thesame period of time; and (2) that their distributions over that period werenearly identical.)
7 Although there is no certainty that the drawing was trulyrandom we have based our conclusions on such an AFFECTING CREDIT RISKIII quate treatment of what we have called moral may be inferred from the data only insofar as they aresuggested by such related factors as stability of employmentand of residence, and character of IN THE ANALYSIS OF BAD-LOANEXPERIENCEOur sample consists of records of actual borrowers, some ofwhom repaid their personal loans substantially as scheduledand some of whom did not. Since these borrowers had al-ready passed through a selection process at the hands ofcredit men, the sample cannot be considered completely rep-resentative of the general run of personal loan results may suffice to show whether or not credit menshould have been more selective than they were, but they donot indicate whether they should have been less is no way of measuring what proportion of rejectedapplications would have proved satisfactory if accepted.
8 Andit is therefore impossible to eliminate the bias attributableto the prior selection of nature of this bias is illustrated in Table 26 whichsummarizes the reasons for the rejection of 1,713 personalloan applicants by a metropolitan bank. The first two rea-sons too much borrowing and weak statement account forabout 50 percent of the total number of rejections and suggestthat the vocational and financial characteristics of theseprospective borrowers were unsatisfactory. Rejections ofthis nature might well be expected to bias the sample.
9 Onthe other hand, rejections for "failure to mention existingloans with other members," a reason which presumably indi-cates dishonesty or irresponsibility, may not bias the sampleappreciably; and the same may be true of the last four itemsin the table. The reason "poor previous credit record with usor others" may indicate dishonesty or irresponsibility, in112 BANKS AND INSTALMENT CREDITTABLE 26 Percentage Distribution of 1,713 Personal LoanApplications Rejected by a Metropolitan Bank, byReason for RejectionREASON FOR REJECTIONPERCENTToo much statement43.
10 9aPoorprevious record with us or to mention existing loans with other members21 .8 Comaker in open legal account with others1 .5 Borrower in open legal account with others1 .5 Judgment record with our consists chiefly of applications showing insufficient income, un-stable employment, unsatisfactory comakers and the case these rejections probably are not a source of , however, rejection attributed to this cause results fromfinancial weakness, it thight well bias the study of credit experience is necessarily based on cer-tain arbitrary assumptions.
