Credit Risk Management Practice Exam

What typically characterizes the "dark side" of retail credit risk?

1. Increased use of automated scorecards

2. Decline in asset values with rising default rates

3. Insufficient documentation of loans

4. Excess liquidity in lending

The correct answer is: Decline in asset values with rising default rates

The "dark side" of retail credit risk is characterized by a decline in asset values coinciding with rising default rates. This scenario commonly emerges during economic downturns or financial crises when borrowers struggle to meet their debt obligations, leading to higher default rates. As defaults increase, the value of the underlying assets, such as homes or vehicles, often decreases due to an oversupply in the market or reduced demand. This relationship amplifies the risk for lenders, as they may face significant losses if collateral values fall below the outstanding loan amounts, thereby affecting the overall stability of their credit portfolio. In contrast, increased use of automated scorecards typically reflects a move toward more efficient risk assessment and management, which does not inherently represent a dark side of credit risk. Insufficient documentation of loans can lead to problems, but it’s more of a symptom than a characteristic – it can create risks but isn't exclusive to the larger economic conditions that define the "dark side." Excess liquidity in lending tends to indicate a market that is actively providing credit, which could contribute to higher risks if not managed properly but is not in itself a defining characteristic of the risks involved in retail credit.