Credit risk is a financial risk which arises due to a payment failure by a borrower. In simple terms, it refers to the risk probability that a lender may not get his due capital and loan repayment which in turn will interrupt cash flow and hinder proper operations of the company or business.
A simple way to avoid credit risk is that lenders must focus on the creditworthiness of borrowers before investing money or providing loans.
Even when it does not completely mitigate the problem as it is not possible to exactly find who will default on their set obligations, it surely lessens the loss.
Credit risk is one of the many financial risks faced by companies, businesses and investors. Their management comes under the purview of financial management and is handled by financial managers in general. Credit Risk Managers are appointed to particularly tackle this kind of risk.
There are several types of credit risk. These mainly include concentration risk, credit default risk, sovereign risk, country risk etc. We will understand all these key points of credit risk in detail.
Credit Risk: Key Takeaways
- Credit risk describes the probability that an insurance company may be unable to make a claim payment or that a bond issuer may not be able to make a payment.
- It is defined as the possibility that any lender may lose his capital when he lends money to a borrower. Often, borrowers that showcase higher risks of credit are provided loans with higher rates of interest.
- A credit score showcases the possibility of a borrower to default and his creditworthiness.
- The major types of credit risk include credit default risk, concentration risk, etc.
What is Credit Risk?
Credit risk is a financial risk that involves the loss of the lender’s capital value and his loan interest value, interrupts the cash flow of the business and leads to an increase in cost collections. It is a risk that arises when there is a probability that the borrower may not be able to fulfill his financial obligations and make payment of loans.
When a lender (company, business or individual) lends capital to a borrower (company, business or individual) in the form of loans, credit cards, mortgages, etc., there are prospects of the borrower not being able to pay the loan. This probability of money loss arising out of loan repayment failures is termed credit risk.
The loss of capital and interest can be severe (complete) or mild (partial). However, it has the capability to disrupt the operations of the business by affecting the cash flow. These losses arise in varied circumstances. Its examples are discussed below.
Examples of Credit Risk Loss
- A consumer or borrower’s failure to repay his loan on a credit card loan, mortgage or any other loan.
- A business’s failure to not pay the trade invoice whenever due and when a business or company does not pay the due salaries to its employees.
- An insurance company’s failure to fulfill policy obligations indicates insolvency. Similarly, an insolvent or bankrupt bank will not return deposited funds to the depositor.
- A business or company’s inability to repay floating charge debt, also called asset-fixed debt.
- Government providing bankruptcy or insolvency protection to a company, business or bank.
Types of Credit Risk
A credit risk can be divided into the following types for better grasp:
- Credit Default Risk
Credit Default Risk is a case of financial risk which arises when the borrower is unable to pay back the loan amount. The time frame to consider a borrower’s default on a loan is 90 days.
It affects all credit-related financial transactions. They incorporate securities, bonds, loans and derivatives. Credit risk may arise because of a change in the economic condition of the borrower or a general recession.
- Concentration Risk
Concentration risk refers to the probability of such an immense financial loss that may affect the core operations of the company and its functioning.
It may arise due to combined sectors of loss or just a single sector.
Concentration risk arises because there is a lack of portfolio diversification. Suppose a corporation has only one major company or business as a buyer. This poses a great concentration risk as there will be a great loss if the buyer stops buying from the corporation.
- Country Risk or Sovereign Risk
Country risk is related to the political instability of a country and its macroeconomic performance. This affects the asset value. It is also called sovereign risk and showcases a government’s inability or unwillingness to fulfill its loan obligations.
The freezing of currency operations by a country poses a country’s credit risk. This results in a default on its financial obligations.
- Counterparty Credit Risk (CCR), Delivery Risk or Settlement Risk
Counterparty credit risk or settlement risk refers to a risk of financial loss due to the failure of a counterparty or an intermediary agent to fulfill its obligations as per the bond, insurance policy or contract.
What is Credit Risk in Banking?
Credit risk is a prominent financial risk in banking as it disrupts the entire cash flow of the company. It arises due to the invested company, business or individual’s failure to repay the capital that is lent by an investor.
Banks analyze the credit history of a borrower and all associated requirements before lending money. If they feel the borrower may be unable to repay the loan, they may not lend money. This is a way to avoid credit risk which arises because the borrower fails to make the repayment.
The failure of a bank to return the deposited funds to the depositor showcases its insolvent nature. The government provides such banks with bankruptcy protection to save them from insolvency and thus protect the deposited money of the people. Thus, banks are required to manage credit risk.
Credit Risk Management Strategies Used by Banks
By making use of credit scores and setting specific lending standards, banks manage credit risk. This way, they monitor the credit score of borrowers, check their creditworthiness, monitor loan portfolios, and make required changes.
There are several ways to calculate credit risk. Generally, it is calculated based on the ability of a borrower to repay the loan following the original terms. There are several ways that banks use to measure credit risk and this can be understood by understanding the five C’s of credit risk.
Understanding the Five C’s of Credit Risk
For the assessment of credit risk on a consumer mortgage or any other loan and management of credit, lenders and banks use the five C’s of credit risk. These are:
- Credit History or Character
- Repayment Capacity
- Capital Amount
- Conditions of loan
- Associated Collateral
These factors are used to prepare the credit score of a borrower which showcases the repayment ability or creditworthiness of the borrower. Different lenders have different ways to use these aspects to make a creditworthiness analysis. This favors better decision-making while making investments and lending money.
Besides, the diversification of loan portfolios and setting up specific loan standards is a great way to prevent credit risk.
Credit Risk Mitigation
There are several ways to mitigate or manage credit risk. These are listed below:
- Loan Diversification: The lenders who lend money to a few of the same kinds of borrowers face a larger credit risk (concentration risk) when compared to those who diversify their borrowers.
- Covenants: Stipulations written on the borrowers by lenders are called covenants. These are specifications written to avoid a debt default. Examples of covenants include periodic reporting of financial condition, refraining from further borrowing, and repayment of the loan in full at the request of the lender in cases of changes in the debt-to-equity or interest coverage ratio of the borrower.
- Credit Tightening: A simple way to reduce credit risk is to tighten or reduce the amount of capital lent or the credit provided. This can be done in total or for particular borrowers that pose a greater credit risk.
- Credit Insurance or Credit Derivative: For credit protection, lenders may take credit insurance or credit derivatives. This is a way to transfer the risk to the seller or insurer instead of the lender.
A common example of a credit derivative is a credit default swap.
- Risk-Based Pricing: It is the method of charging interest rates in proportion to the credit score of a borrower. In simple terms, lenders charge high rates of interest to borrowers with a greater possibility of default.
- Deposit Insurance: Deposit insurance is issued by governments to guarantee or protect debt deposits and save cases of insolvency. They also encourage the customers to keep their savings in the banks instead of encashing them.
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Credit Risk FAQs
Q1. What are the types of credit risk? Explain.
Ans: There are several types of credit risk. However, the four most important types of credit risk include the following:
Settlement Risk: It arises when the intermediary agent fails to deliver a value or security according to the scheduled trade agreement. Thus, it is also called delivery risk.
Sovereign Credit Risk: It is the risk associated with governments. It arises when governments are unable to fulfill their loan obligations.
Concentration Risk: A financial risk of a large enough financial loss that may affect the functioning or core operations of a business. This may arise due to a single loss or a group of losses combined.
Credit Default Risk: It is the credit risk that arises due to a borrower’s inability to repay the loan amount and the borrower is past 90 days due on his credit or financial obligations.
Q2. How do banks manage credit risk?
Ans: Credit risk can be managed by making use of the five Cs of credit risk. It includes capital, loan conditions, collateral, capacity and character. Loan loss provisions and diversification of loan portfolios are some other ways to manage credit risk.
Q3. Who is a credit risk manager?
Ans: A credit risk manager is a financial manager who analyzes, manages and prevents the risks of lending money via mortgages, credit cards and other loans to borrowers. They work in companies, businesses, investment banks, finance consultancies, credit unions, insurance companies, etc.
