In this topic “What is credit risk? “, we will discuss the meaning of credit risk, the comparison between credit risk and interest rates, factors considered before credit risk is accessed, bank and lending institutions, forms of credit risks, and utility of credit ratings.
Sometimes, individuals borrow money from lending institutions, without being able to pay it back. The probability of the banks or lenders losing funds due to a lack of returns is what we call credit risk.
Meaning of a Credit Risk
We have banks and lending institutions that give out money to people in return for some percentage of profits. But before this money is given out, some calculations are done. They are called credit risks. Individual loans, enterprise loans, and even national debt are calculated using credit risk.
Credit risk is one of the most valuable tools for lending institutions or banks. When it comes to consumer finance, there are factors that determine the calculation of credit risk. They are credit history, repayment capacity, capital, lending conditions, and collateral. For example, if you don’t have capital but collateral is present with a good credit history, you will stand a chance of higher credit risk. They all work hand in hand, one cannot exist without the other. It is important for lending institutions to reduce the risk of borrowers who were not able to pay back their loans.
The way the above-mentioned factors correlates depends on complex algorithms and financial calculations. However, when credit risk is measured, it is important to note down things considered.
For example, if a person with high credit risk goes to a traditional lender, their collateral might be rejected. However, as the percentage of people with credit ratings is gradually increasing, there are lending institutions that also handle borrowers with high credit risk. The ones with credit histories that are manageable are considered by subprime mortgage lenders. However, don’t forget that they often have inflated interest rates and APR terms that are noticeable.
More On Credit Risks
Most banks and lending institutions focus more on the risks associated with borrowers that were unable to pay back their loans. Within these lending institutions, we can locate dedicated credit risk management departments. They are responsible for calculating the individual credit risk score for borrowers new to the system. These departments are also in charge of accessing risk for the loan value of both the bank and lending institution. It will be beneficial if banks avoid high exposure to risks. If the bank doesn’t, it will be detrimental.
In the crypto space, the idea of credit risk is still a new story. Traditionally, some principles of risk calculation are already conversant with the crypto world. For example, in order to enable safe investments, borrowers use themselves as collateral.
The most important safety measures adopted by banks while giving out funds are risk management and risk aversion.
Credit Risk Fully Elaborated
Credit risk is the possibility of a lender encountering loss due to default from borrowers. Traditionally, this loss interrupts the flow of cash and leads to an increase in collection costs. The high credit risk a lender normally faces can be lessened by the introduction of high coupon rates. Excess cash flows may be introduced to serve as an alternative for managing credit risk. Hence, leading to an increase in cash flows.
The lender’s reward for predicting credit risk is the interest payments imposed on borrowers. However, it’s impossible to know the exact person who will fail to pay back. But proper credit risk management and assessment can reduce the loss incurred.
- Credit risk is the possibility of a lender encountering loss due to default by a borrower.
- Consumer credit risk can be determined by credit scores, repayment capacity, capital, conditions associated with loans, and collateral.
- Consumers with higher credit risks suffer high-interest rates on loans.
Knowledge of Credit Risk
Credit risk also extends to those that issue bonds as well as insurance companies not being able to meet up with the agreed terms. There is a possibility of a borrower defaulting even after seeing offers like mortgages, credit cards, or other types of loans. Similarly, if a company offers credit to a customer, it is possible for those customers to owe invoices.
Calculations of credit risks depend on whether the borrower goes against the original agreement or not. However, credit history, capacity to repay, capital, the loan’s conditions, and associated collateral channels through which lenders account for borrower’s loans.
Data used to assess a customer’s risk profile can be analyzed by companies. This was made possible by technology. Some businesses have set up divisions that can access the credit risks of their current and potential customers.
For example, there is a review of credit rating when an investor considers buying a bond. If it is low (< BBB), the seller will likely not adhere to the terms. Conversely, if the rating is higher (BBB, A, AA, or AAA), there’s a low risk of not obeying terms.
There are agencies responsible for this review. Moody’s Investors Services and Fitch Ratings are examples. They review the credit risks of thousands of corporate bond sellers and municipalities on a regular basis. For example, an investor with strong opposition to risks may prefer to buy a highly-rated municipal bond. On the other hand, an investor that loves taking risks may buy a BBB-rated bond with the hope that it will yield higher returns.
Comparison Between Credit Risk and Interest Rates
Investors and lenders usually request a higher rate of interest. This applies only when they suspect a higher level of credit risk.
They may also opt to forfeit the investment or loan.
For example, a borrower with good credit history usually receives a low-interest rate. This happens because they see it to have low credit risk. But if the reverse becomes the case, they may have to work with those that offer loans with relatively high-interest rates for profit making. There are credit repair companies that are best in helping a high-risk borrower to acquire lower interest rates. They do this by working on the development of credit history.
Similarly, bond sellers with low credit ratings offer higher interest rates than those with very high credit ratings. The former attracts customers with the assurance of higher returns.
Mission Of Project Finance
Project finance in risk management has a mission of understanding, measuring and watching over the various risks encountered. They also obey rules safeguarding risk issues. Firms have established a credit approval process. It contains the methods of accessing credits. The project finance part of a bank is exposed to risks associated with lending and trading activities and the environment they are involved in.
For more info, check out CFI’s Credit Analyst Certification program.
Factors Considered before Credit Risk is Accessed.
The risks associated with the borrower and the important company are first accessed before any other activity is carried out.
You can consider the following before evaluating a borrower’s credit risk:
- The financial position of the borrower. The quality of the borrower’s financial statements, financial history, and flexibility are all analyzed. This determines the ability to raise capital, and how sufficient the capital is.
- The relative market position of the borrower and how efficient the operations are.
- The track record, payment record, and financial storage are all analyzed. This helps to maintain quality.
To evaluate the credit risk of a particular industry, you will consider these:
- Properties like the importance of the industry to economic growth and government policies relating to the industry.
- How challenging the industry is.
- Stability of income returns made from the capital, and operating margins.
Utility of Credit Ratings
Most firms accept a scale of ratings ranging from AAA to BB. They include a default rating of D, but they all vary with firms. Firms give a particular credit rating, after a series of analyses. They conduct this in terms of specific borrower risk. Credit ratings are important tools for the credit approval process. They help the industry determine a particular credit risk associated with its cost of funds. They consider the credit rating of the borrower and the default method that rhymes with it.
The sector of credit risk management reviews all the proposals for a facility. After then, it transfers it to the authority for approval. Generally, the approval process for both non-fund and fund-based facilities is alike.
Time factor in Assessment of Credit Ratings
You can examine it yearly. t the same time, you can examine the one of large exposure regularly. However, with any activity causing an impact, anyone can examine the ratings of all borrowers in a specific industry.
In general, you can validate a working capital loan under a period of 12 months.
After this, the industry decides whether the process continues or not. They also decide whether the loan terms remain the same. You can achieve this when you examine both the loan covenants and the credit rating of the borrower.
A credit risk is a risk that occurs when a borrower fails to make required payments according to agreements made. Firstly, it is the lender who encounters this type of risk. They include lost principal and interest, disruption to cash flows, and high cost of collection. In an efficient market, higher levels of credit risk are associated with higher borrowing costs. Yield spreads reduce credit risk levels but it depends on market participants’ assessment. However, the loss may be complete or incomplete.
The following can increase losses made:
- Default by consumers on a mortgage loan, credit card, line of credit, or another loan.
- A company owes an asset-secured fixed or floating charge debt.
- A business or consumer does not pay a trade invoice when due.
- Seizing an employee’s earned wages when the time for payment arrives.
- Failure of a business or government bond seller to make a payment on a coupon or principal payment when the time reaches.
- When a bankrupt insurance company owes a policy obligation.
- A bank suffering bankruptcy fails to repay a depositor.
- A government grants bankruptcy protection to a consumer or business with insufficient assets.
Whenever borrowers from a bank are in debt, credit risk surfaces. To reduce that of a lender, the lender may ask the borrower to take out appropriate insurance. Or better still request for a guarantee from another individual, or seek security over some of the borrower’s properties. The lender can also remove insurance against the risk or maybe transfer the debt to another company. In general, the interest rates vary directly with the risks.
Forms of Credit Risk
Credit risk can occur in the forms below:
- Credit default risk – This risk occurs when a debtor owes a loan or an asset for up to 3 months. It may also impact all transactions that are sensitive to credit. Examples are loans, securities, and derivatives.
- Concentration risk – The risk has the ability to disturb the major bank operations thereby causing huge losses. It may arise in the form of an individual or industry concentration.
- Country risk – This occurs when a sovereign state blocks foreign currency payments (transfer/conversion risk) or when it fails to meet up with terms (sovereign risk). They usually associate with the political stability of a country as well as its macroeconomic performance.
How is Credit Risk Accessed?
Important resources and advanced programs are the tools for risk management and analysis. They may use internal programs to avoid, reduce and transfer risk. They also use intelligence made available by a third party. Some industries charge people for such services. Examples are Standard & Poor’s, Moody’s, Fitch Ratings,
DBRS, Dun and Bradstreet, Bureau van Dijk and Rapid Ratings International. However, some run a credit risk department that monitors the financial health of their customers and extends credit.
In reference to price loans or collateral seeking, large companies with fairly traded corporate bonds have features like bond yield spreads and credit default swap spreads which indicate market participants’ assessments of credit risk.
More On Accessing Credit Risk
In order to grade potential and existing customers according to risk, most lenders involve the person they emulate. They also employ appropriate procedures. They charge a higher price for higher-risk customers and vice versa because of products that lack security. But for revolving products like credit cards, credit limit controls the risk. Some products also require collateral, usually a mortgage.
For corporate and commercial borrowers, these models generally have qualitative and quantitative sections. They listed the various aspects of the risk like operating experience, management expertise, asset quality, and leverage and liquidity ratios. Although it goes beyond the aspects listed above. The lender will provide the funds in view of the terms and conditions. Credit officers and committees go through the list to make this happen. Credit scoring models are also part of the tools used by banks or lending institutions to give clients access to credit.
Sovereign credit risk is the risk of a government defaulting on loan terms. In the past years, a lot of countries have faced this same risk. Their existence alone signals that creditors should think twice when deciding to lend to a firm based in a foreign country. Let us consider, the sovereign risk quality of the country and the firm’s credit quality
Explanation of Sovereign Credit risk
Below are the macroeconomic variables that affect the probability of changing the schedule of sovereign debt:
- Debt service ratio
- Import ratio
- Investment ratio
- The variance of export revenue
- Domestic money supply growth
You will gain a lot from future economic productivity. This tends to reduce the ratio of investments. The investment ratio is directly proportional to the probability of debt rescheduling. The foreign country could become independent of its external creditors. In contrast, the debt service ratio, import ratio, the variance of export revenue, and domestic money supply growth are increased.
Explanation of Counterparty Credit risk
A counterparty credit risk (CCR), is a risk built on a bond, derivative, insurance policy, or another contract that has no business with the counterparty. Another name for it is default risk. Financial institutions or other transaction counterparties may take out credit insurance or require the posting of collateral in the derivative aspect. Removing risks associated with counterparty doesn’t succeed all the time. This might be due to temporary liquidity issues or any other reason. Correlated risk factors tend to increase the level of counterparty risk. Therefore it is very important to study this correlation between portfolio risk factors and counterparty default in risk management.
We calculate capital requirement with SA-CCR, (Standardized approach for counterparty credit risk). This approach replaced both Current Exposure Method (CEM) and Standardized Method (SM). This pattern is sensitive to risks. This means that they are conscious of asset class and reduction of financial risks, and they recognize netting benefits. They are aware of the issues that are not addressed properly.
I believe the topic “What is credit risk? “, impacted more knowledge to you. You can research more on the meaning of credit risk. Also, read more on the comparison between credit risk and interest rates. Study the lending institutions, forms of credit risks, and utility of credit ratings.