In the world of finance, the process of crediting and debiting any amount is the most common occurrence. May it be personal loans or loans taken from higher financial authorities like banks, credit always consists of a lender and a borrower and there is always ‘good credit’ and ‘bad credit’.
With loans comes risk, and credit risk is one such risk of the lender where he/she may not receive the amount they have lent. In this article, we are going to discuss the following:
(Related read: 4 Types of Financial Risk)
What is Credit Risk?
As the name suggests, Credit risk refers to the probability of a loss occurring to a lender as a result of a borrower's inability to repay a loan or meet contractual commitments.
Traditionally, it might indicate the likelihood that a lender will not take the owing principle and interest. As a result, cash flows are disrupted and collection expenses are increased.
Similarly, if a firm extends credit to a consumer, there is a chance that the customer would fail to pay their debts. Credit risk also refers to the possibility that a bond issuer will fail to make a required payment or that an insurance company will be unable to pay a claim.
As per Investopedia, Credit risks are determined by the borrower's overall capacity to repay a loan following its original conditions.
Lenders use the five Cs when assessing credit risk on a consumer loan: credit history, repayment ability, capital, loan terms, and collateral. Some businesses have created departments that are entirely responsible for analyzing the credit risks of their present and prospective clients. Businesses may now swiftly evaluate data needed to determine a customer's risk profile thanks to advances in technology.
(Also read: 4 Types of Credit Derivatives)
When an investor contemplates purchasing a property, they will frequently look at the bond's credit rating. If the rating is low ( < BBB), the issuer is at a significant probability of insolvency.
Conversely, if it has a higher rating (BBB, A, AA, or AAA), the danger of failure decreases gradually. Bond-rating organizations, such as Moody's Investors Service and Fitch Ratings, continuously assess the credit risks of hundreds of corporate debt issuers and municipalities.
A risk-averse investor, for example, may choose to purchase an AAA-rated municipal bond. A risk-taking investor, on the other hand, may purchase a bond with a lower rating in exchange for possibly larger returns.
(Recommended read: An Introduction to Capital Budgeting)
What are the types of Credit Risks?
Now that we have a clear understanding of what credit risks are, let us look at the three types of credit risks, according to ClearTax:
Credit spread risk:
This risk occurs as a result of volatility in the gap between the interest rates on investments and the risk-free return rate.
When a borrower is unable to fulfill contractual payments, the risk of default increases.
The danger of a downgrade arises when an issuer's risk rating is downgraded.
(Also read: Introduction to Investment Banking)
How are Credit Risks assessed?
A bank's project finance division is susceptible to risks unique to its lending and trading operations, as well as the industry in which it works, as a financial intermediary. The main aim of project finance in risk management is to guarantee that the company knows, measures, and monitors the different risks that occur, as well as that the policies and procedures in place to address these risks are carefully followed. And, to decrease the dangers, they must first be assessed.
The firm's project finance division evaluates several about examining risks about the borrower and the relevant sector before assessing the credit risk connected with any financial proposal.
To evaluate the credit risk of a borrower, the following factors are taken into consideration:
The relative market position and operational efficiency of the borrower are considered.
The borrower's financial condition is assessed by looking at the quality of its financial accounts, historical financial performance, financial flexibility in terms of capital raising, and capital sufficiency.
By examining its track record, payment record, and financial conservatism, you may determine the quality of management.
The following factors are used to assess industry-specific credit risk:
Certain industry features, such as the industry's importance to the economy's economic growth and government policies affecting the industry.
Financial data from the industry, such as return on capital employed, operating margins, and profits stability.
The competitiveness of the industry is also noted.
(Related blog: What is a Credit Rating?)
Use of Credit Ratings:
Credit ratings are an important part of the credit approval process because they allow the company to calculate the required credit risk, which is distributed across its cost of funds, by taking into account the borrower's credit rating and the default pattern associated with that credit rating.
The credit risk management group gives a credit rating to the borrower after examining the borrower's risk. Firms often accept a rating range ranging from AAA to BB (which varies by business) as well as a default grade of D.
Every borrower's credit rating is examined at least once a year, and it is generally assessed more frequently for high credit risks and big liabilities. Generally, each important event affecting an industry's ratings is evaluated, as are the ratings of all borrowers in that industry.
The majority of working capital loans are granted for a 12-month term. The loan agreement and the borrower's credit rating are evaluated at the end of the 12-month validity term, and the company decides whether to continue the arrangement and make any required adjustments to the loan covenants.
(Must check: Ways to Improve Credit Score)
How to reduce Credit risk?
When a significant percentage of credit sales are concentrated with a small number of customers, credit risk is a particular issue, because the collapse of any one of these customers might severely impact the seller's cash flow. When a high percentage of sales are made on credit to clients in one nation, and that country has interruptions that prevent payments from that country, a similar risk develops. In essence, any sales concentration raises credit risk.
To reduce the chances of credit risk, there are many ways. Some of them are discussed below:
Credit insurance on any invoices provided to the customer is the most straightforward way for a firm contemplating the provision of credit to a client to decrease its credit risk and may even be able to bill the customer for the cost of the insurance.
Another option is to impose extremely short payment terms so that credit risk is only present for a short time.
A third alternative is to send the consumer to a distributor and transfer the risk to the distributor.
A fourth approach is to demand a personal guarantee from someone with significant personal assets.
If a lender wants to reduce its credit risk, it can raise the interest rate on any loans it issues, requires substantial collateral, or impose a variety of debt covenants that allow it to call the loan if it is breached, and force the customer to pay off the debt before spending money on other things.
(Similar read: 5 Ways to Improve Credit Score)
There is no doubt that during such transactions, the lenders or the borrowers face some risks. Credit risk can result in the loss of both interest and unpaid principal in the event of an unpaid loan, but there is no loss of interest in the case of an outstanding account receivable.
In both situations, the creditor may be subject to additional collection fees. Furthermore, the party owing money may experience some disturbance in its cash flow, which may need the use of expensive debt or equity to compensate.
So, it is very important to evaluate the causes of credit risk and work on it to reduce the risk. In this article, we have discussed the definition of credit risk, the factors based on which credit risk is calculated, and a few ways to mitigate credit risk.