Credit Risk Examples

Article byTanmay Agarwal
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Credit Risk Examples

The following Credit Risk example provides an outline of the most common Credit Risk. It is impossible to provide a complete set of examples that address every variation in every situation since there are thousands of such Risks.

Credit risks refer to the risks of loss on a debt when the borrower fails to repay the principal and related interest amounts of a loan back to the lender on due dates. In this section, we will see some practical examples of credit risks to understand them better.

  • When a lender offers credit to the counterparty (through loans, credits on invoices, investing in bonds, or insurance), then there is always a risk for the lender that it might not receive the credited amount back from the counterparty. Such risks are termed credit risks or counterparty risks.
  • It calculates the overall ability of a borrower to pay the loans back to the lender. To avoid or reduce credit risks, a lender generally checks the credibility and background of the borrower.
  • With high credibility (which means low credit risks), a borrower can receive a higher amount of loans without attaching collaterals to the contract; otherwise, the loan will be allotted according to the value of security attached as collateral.

Key Takeaways

  • Credit risks are the chances that a lender will suffer a loss on a loan when the borrower defaults on making principal and interest payments on time.
  • Rating agencies can’t always forecast outcomes accurately, so the investor must confirm the credit risks of the businesses they intend to invest in.
  • The company’s financial statements are available for review by investors. The company’s credit rating will be lower if operating cash flows are higher. Using a formula for ratio analysis, such as the interest coverage ratio, gauges a company’s capacity to pay off its debt.
Credit Risk Examples

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Top 3 Credit Risks Examples

Each example of the  Credit Risk states the topic, the relevant reasons, and additional comments as needed.

Example #1

Assume Tony wants his savings in bank fixed deposits to get invested in some corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face more as it can provide higher returns. However, he is aware that bonds include counterparty default risks or credit risks, i.e., the bond issuer will default, and Tony will not receive any of the promised cash flows.

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So Tony decides to price these risks to get reimbursed for the extra risk he is going to be exposed to. He finds the two basic measures of credit risks are:-

  • Credit Risk Scores – Every institution and individual uses qualitative and quantitative factors to measure such risk of borrowers. Lenders use credit risk scores to allow or reject the loan application. A credit score is expressed in a numerical format that ranges between 300 and 850, where 850 is the highest credit score possible.
  • Bond Credit Ratings – Publicly traded companies that issue bonds have been rated by rating agencies like Moody’s, Standard and Poor (S&P), Fitch, etc. The rating is a grade in an alphabetical format that gets assigned to a bond. E.g., the ratings by S&P may vary from AAA (safest company) to D (a company in default).

The advantage of investing in a rated company is that the investor has a sense of what the rating agencies think about the company’s credit risk. Also, rating helps the investor to charge an appropriate spread for taking the extra risk called default spread.

E.g., let’s say Tony purchased a 10-year bond with a ‘BBB’ rating. The default spread for a similar bond is 1.84%, and the risk-free rate for a 10-year bond is 1.5%. So the interest rate demanded by Tony must be (1.84 + 1.5) 3.34%.

However, rating agencies cannot always make accurate predictions, and it becomes the responsibility of the investor to double-check the credit risks of the companies they want to invest in. The following are some basic factors to help investors measure the risk of the company:-

Interest Coverage Ratio = EBIT/Interest Expenses

Let’s say Tony investigates a company with earnings before interest and taxesEarnings Before Interest And TaxesEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of more (EBIT) of 3500 million and interest expenses of $700 million.

Credit Examples 1

Thus Interest coverage ratio = 3500/700 = 5

According to various agencies’ data, the companies with an interest coverage ratio between 4.5% to 6% have a rating of ‘A-,’ and their relative default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other more is 2.5%. I.e., Tony should charge a 2.5% higher interest rate than the risk-free ratesRisk-free RatesA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of more.

Example #2

Let’s say Mr. Tony and a businessman run a clothing wholesale business limited to the New York City of America. To expand the business, he started providing large credits to its customers without any definite credit policy and credibility checks.

Tony neglects to consider the inflated credit risks. At year-end, he finds some of his customers are not paying their invoices on due dates. Upon investigating the background of his clients, he finds that a few have very low credibility.

With low client credibility, the credit risks to Tony inflates heavily, and there might arise a possibility that he might not get reimbursed for the goods he supplied to its clients.

None/ low payments of regular invoices negatively affect the cash flows of Tony’s firm and cause losses to the entity, generally referred to as bad debtsBad DebtsBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other more.

To avoid such risks, Tony should structure an effective credit policy and properly check the credibility of its customers before offering any credit or loan.

Example #3

Assume Mr. Tony wants to purchase a car worth $120,000. He paid an amount of $20,000 as a down paymentDown PaymentDown payment is the initial deposit made by the buyer to the seller when purchasing an expensive item, such as residential property or a car. It comprises a portion of the total purchase amount of the asset and takes place via cash, bank check, credit card, or online banking. read more and decided to take a bank loan for the remaining amount of $100,000 at the rate of 20% per annum to be paid in 1 year.

This means the bank needs to receive $120,000 back in one year from Tony. The bank’s risk management checked Tony’s credit risks before issuing the loan, i.e., the possibility that he might not be able to repay the loan or installments on the due date.

With higher credit risks, Tony’s loan application may get rejected by the bank, or the bank will allocate a lower sum of money that suits his credibility (ability to repay the loan) criteria. Tony, with a low credit risk count, gets the approval for loan allotment.

Tony successfully paid a couple of installments of $10,000 each. But during the year, Tony made some big losses in his business due to offering goods on credit to customers with low credibility and applying liberal credit policies.

The bank thinks Tony might not be able to make any further payments against the loan. The current situation creates huge risks to the bank against a loan provided to Tony.

Frequently Asked Questions (FAQs)

What are credit risk example scenarios?

During the financial crisis, a few instances of credit risk were highlighted, including those of consumers who could not make mortgage payments. These loans were subprime mortgages with adjustable rates that increased annually during the financial crisis.

What are credit risk models?

A bank uses a credit risk model to calculate the PDF of a credit portfolio. In this sense, structural and reduced-form models are the two major categories of credit risk models. Based on the value of a company’s assets and obligations, structural models are used to determine the likelihood that a default will occur.

Q. Why credit risk management is critical?

Lenders must control their credit risk because they stand to lose money if borrowers fail to repay their debt. This loss may impact the lender’s cash flow if significant enough.

Recommended Articles

This has been a guide to Credit Risk Examples. Here we discuss the top 3 examples of credit risk and some basic factors that help investors measure the company’s risk. You can learn more about financing from the following articles –