What is Credit Risk? 3 Types of Risks and How to Manage Them

What is Credit Risk?

The default risk on a debt that arises from a borrower who fails to make the required payments is called Credit Risk. Any lender would include this as a first resort which includes principal and interest along with disruption to cash flows and the collection cost. The loss may be partial or even complete in many cases. Higher borrowing costs are always associated with higher credit risk levels in an efficient market. Due to this reason, the cost of borrowing can be used to conclude credit risk based on the assessment by the participants of the market.

Few cases in which losses can arise when a consumer fails to make the payment or when a company is unable to repay an asset secured debt. They also arise when a consumer is unable to pay an invoice when it is due or when a business does not pay salaries to its employees on time.

A credit check is performed by the lender to reduce this credit risk on the prospective borrower and it may require the borrower to take insurance which guarantees from a third party of the payment to the lender. In other cases, mortgage insurance or security over assets can be used for credit. In general, the interest rate will depend on the credit risk, which means higher there is higher will be the interest. Credit risk increases when the borrowers, willingly or unwillingly, are unable to pay.

Credit risk assessment

The risks are calculated on the borrower’s ability to repay the loan. To assess the credit risk the lenders, look at the five C’s of the borrower. The five C’s are credit history, capacity to repay, capital, the loans condition, and associated collateral. Some companies have a dedicated department only for assessing the credit risk of its current and potential consumers.

Due to the help of technology businesses can now analyze the data quickly and assess customers credit risk profile. If an investor is evaluating to buy a bond, he will review the credit rating of the bond before the purchase is made. If the rating is low then the issuer is considered to have a high credit risk of default and alternatively, if it has a high rating then it is considered to be a safe investment.

Types of Risks

1) Credit Default Risk

The risk of loss which arises from the debtor being unlikely to repay the amount in full or when the debtor is more than 90 days past is the due date of credit payment, it gives rise to credit default risk. The Credit default risk impacts all the sensitive transactions which are based on credit like loans, derivatives or securities. Credit default risk is also checked by banks before approving any credit cards or personal loan.

2) Concentration Risk

This is the type of credit risk which is associated with exposure of any single or group with the potential to produce large losses to threaten the core operations of a bank. It may arise in the single form of single name concentration even industry concentration.

3) Country Risk

The risk which arises from a sovereign state when it freezes the payments for foreign currency overnight defaults or its obligation which is termed as sovereign risk. Country risk is exclusively associated with the performance of macroeconomics of a country and is also closely related to the political stability in the country.  Sudden instability, which tends to happen during the elections, results in high country risk.

Mitigation of Risks

There are multiple ways to mitigate the credit risk which are as follows:

A) Best Credit Risk-Based Pricing

The lenders usually charge a higher rate of interest to borrowers who are defaulters. This practice is known as risk-based pricing. The lenders take into consideration the factors such as on purpose credit rating and loan to value ratio.

B) Credit insurance and credit derivatives

Bondholders hedge the risk by purchasing credit derivatives or credit insurances. These contacts ensure the transference of the risk from the gender to the server against a specific amount of payment. Credit default swap is the most common form of credit derivative used in the market.

C) Best Covenants

Stipulations may be written by lenders to the borrowers which are called covenants. These are usually written into loan agreements such as a periodic report about the financial condition, refrain from paying dividends or further borrowing of amount or any other specific action that affect the company’s financial position in a negative way or repayment of the full loan at the request of the gender in events such as borrower changes or changes in debt to equity ratio or change in interest coverage ratio.

D) Diversification

Lenders diversify their borrower pools and reduce the risk.

Calculating Credit Risk

The overall payment ability of the payer is calculated to determine the credit risk. The analysis of calculating risk takes into consideration the revenue generating ability of the borrower along with current assets with the borrower and taxing authority.

Credit risk calculation can be done in the following way

A standardized credit score such as FICO score is determined of the borrower. The FICO score helps in determining the credit history, repayment capacity and creditworthiness of an individual. On one hand, the FICO score indicates the way in which an individual makes the repayment of his debts, it does not ensure repayment in the future.

The next step in calculating credit risk would be to calculate Debt-to-income ratio. This is calculated by monthly recurring debts of a company and divided by gross monthly income. The individuals who have a score of less than 35% are considered as acceptable credit risk.

The last step is to factor in the potential loan of the borrower. The potential loan would be the debt which can be taken by the borrower on the basis of his credit cards and other general creditworthiness. This gives a potential of loan and payment capacity of the borrower.

Such risk calculation is done with every customer so as to assess the nature of the credit risk that the debtor is dealing with.