What is Credit Risk?
Credit Risk is the probability of a borrower defaulting on debt obligations. Lenders risk not receiving the principal and interest component of the debt. This can result in an interrupted cash flow and increased cost of collection.
Financial institutions analyze the credit risk associated with each borrower to reduce losses and fraudulent activities. The term can be extended to other similar risks—a bond issuer may not be able to make payment at the time of its maturity, or an insurance company may not be able to pay a claim.
Table of contents
- Credit risk is the uncertainty faced by a lender. Borrowers might not abide by the contractual terms and conditions.
- Financial institutions face different types of credit risks—default risk, concentration risk, country risk, downgrade risk, and institutional risk.
- Lenders gauge creditworthiness using the “5 Cs” of credit risk—credit history, capacity to repay, capital, conditions of the loan, and collateral.
- The following formula is used to find the expected loss on debts:
Expected loss = Probability of default × Exposure at default × Loss given default
Credit Risk Explained
A robust credit risk managementCredit Risk ManagementCredit Risk Management is the process of mitigating the risk associated with each security in a portfolio. There are various ways to eliminate the potential risks posed by a market. predicts negative circumstances and measures the potential risks involved in a transaction. To manage risk, most banks rely on technological innovations. But these, risk management systems are very expensive. The system measures, identifies, and controls credit risk as part of Basel IIIBasel IIIBasel III is a regulatory framework designed to strengthen bank capital requirements while also mitigating risk. It is an extension in the Basel Accords, designed and agreed upon by members of the Basel Committee on Banking Supervision. implementation.
To determine the right amount that can be lent to a borrower, financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. use credit risk modeling. It is an alternative to traditional pricing techniques and hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.. Lenders use various models to assess risks—financial statement analysis, machine learning, and default probability. But, at the end of the day, none of the methods provide absolute results—lenders have to make judgment calls.
Types of Credit Risk
Credit risks are classified into three types:
#1 – Default Risk
It is a scenario where the borrower is either unable to repay the amount in full or is already 90 days past the due date of the debt repayment. 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 factors. influences almost all credit transactions—securities, bonds, loans, and derivatives. Due to uncertainty, prospective borrowers undergo thorough background checks.
#2 – Concentration Risk
When a financial institution relies heavily on a particular industry, it is exposed to the risk associated with that industry. If the particular industry suffers an economic setback, the financial institution incurs massive losses.
#3 – Country Risk
Country riskCountry RiskCountry risk denotes the probability of a foreign government (country) defaulting on its financial obligations as a result of economic slowdown or political unrest. Even a little rumour or revelation can make a state less attractive to investors who want to park their hard-earned income in a reliable place. denotes the probability of a foreign government (country) defaulting on its financial obligations as a result of economic slowdown or political unrest. Even a small rumor or revelation can make a country less attractive to investors. The sovereign riskSovereign RiskSovereign Risk, also known as Country Risk, is the risk of a country defaulting on its debt obligations. It is the broadest measure of credit risk and includes country risk, political risk, and transfer risk. mainly depends on a country’s macroeconomicMacroeconomicMacroeconomics aims at studying aspects and phenomena important to the national economy and world economy at large like GDP, inflation, fiscal policies, monetary policies, unemployment rates. performance.
#4 – Downgrade Risk
It is the loss caused by falling credit ratingsCredit RatingsCredit rating process is the process in which a credit rating agency (preferably third party) analyzes a security and rates it accordingly so that the stakeholders can make their investing decisions.. Looking at the credit ratings, market analysts assume operational inefficiency and a lower scope for growth. It is a vicious cycle; the speculation makes it even harder for the borrower to repay.
#5 – Institutional Risk
Borrowers may fail to comply with regulations. In addition to the borrower, contractual negligence can be caused by intermediaries between the lenders and borrowers.
Calculation and Formula
To gauge creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan., lenders use a system called “The 5Cs of Credit Risk.”
- Credit history: Lenders look into borrowers’ credit scores and check their backgrounds.
- Capacity to repay: To ascertain borrowers’ repayment ability, lenders rely on the debt-to-income ratio. It indicates efficiency in paying off debts from earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments..
- Capital: Lenders determine every borrower’s net worthNet WorthThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus.. It is computed by subtracting overall liabilities from total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity.
- Conditions of loan: It is important to determine if the terms and conditions suit a particular borrower.
- Collateral: Lenders assess the value of collateral submitted by borrowers. CollateralizationCollateralizationCollateralization is derived from the term "collateral," which refers to a security deposit made by a borrower against a loan as a guarantee to recover the loan amount if s/he fails to pay. mitigates lenders’ risk.
One of the simplest methods for calculating the expected loss due to credit risk is given below:
Here, PD refers to ‘the probability of default.’ And EAD refers to ‘the exposure at default’; the amount that the borrower already repays is excluded in EAD. LGD here, refers to loss given default Loss Given DefaultLGD or Loss Given Default is a common parameter to calculate economic capital, regulatory capital, or expected loss. It is the net amount lost by a financial institution when a borrower fails to pay EMIs on loans and ultimately becomes a defaulter.. If LGD is not given, it is calculated as ‘1 – recovery percentage.’
Credit Risk Example
Let us assume that a bank lends $1000,000 to XYZ Ltd. But soon, the company experiences operational difficulties—resulting in a liquidity crunch.
Now, determine the expected loss that could be caused by a credit default. The loss given default is 38%; the rest can be recovered from the sale of collateral (building).
Exposure at default (EAD) = $1000,000
Probability of default (PD) = 100% (as the company is assumed to default the full amount)
Loss given default (LGD) = 38%
The expected loss can be calculated using the following formula:
Expected Loss = PD × EAD × LGD
Expected Loss = 100% × 1000000 × 38%
Expected Loss = $380000
Thus, the bank expects a loss of $380,000.
Frequently Asked Questions (FAQs)
Risk analysis is the process of interpreting the credibility of borrowers. It ascertains repayment efficiency. The process determines the level of uncertainty involved with each borrower.
Effective risk management strategies include periodic MIS reporting, risk-based pricing, limiting sector exposure, and inserting covenants.
Following are four risk mitigation methods:
1. Staying clear of high-risk business activities.
2. Accepting risk and preparing for it.
3. Taking measures to reduce or control the impact of uncertainties.
4. Mitigating risk by acquiring insurance—transferring risk onto other entities.
This has been a guide to guide to what Credit Risk means. We discuss credit risk definition, types, modeling, analysis, banking, credit ratings, credit scores, risk mitigation, risk assessment & analyst jobs. You can learn more about financing from the articles below –