Credit Risk: Explanation and Management
What is a risk? Many things we do every day are related to the concept of risk. If the risk is too high, you may regret having taken the risk, especially if you lose or things do not go as planned. A good example would be an item that you really want to get, but you are not purchasing it because you are waiting for it to go on sale. You are risking that the item will no longer be available at the time of sale or there will be no sale at all.
In everyday language, risk often has a negative connotation or as a synonym of the probability of loss or danger. Economic risk is the kind of risk that affects the performance of businesses and is closely related to the balance between costs and revenues. Businesses, individuals, and various other entities take the risk because they expect to receive profit or other benefits. Credit risk is one of the several risks financial institutions are facing.
Definition
Credit risk is the risk of the borrower not fulfilling its obligations in relation to the lender. It can also be considered the possibility of the borrower’s refusal to pay interest and/or return the principal debt due to the lender. Credit risk arises in all types of lending operations, both domestically and internationally. Default risk, as it is also often referred to, is the most serious risk faced by banks.
Credit risks are borne primarily by banks and other financial institutions that give loans to businesses and individuals. At the same time, the possibility of bank bankruptcy contains a credit risk for its depositors. There is also a chance that an insurance company might default on its payment obligation when a legitimate claim is filed. Corporate bankruptcy carries credit risk for the holders of the stock or bonds of the company. Political instability is a source of credit risk for holders of government bonds.
Risk Management
The degree of credit risk depends on the borrower, their economic situation, the general economic situation, and the form of the loan. The variety of types of credit operations predetermines the characteristics and causes of credit risk:
- simple dishonesty of the borrower who received a loan
- weakening of the competitive position of a particular enterprise to which a bank or other financial institution granted the loan
- unfavorable economic conditions
- ineffectiveness enterprise management, mistakes, and miscalculations in assessing market conditions, etc.
The negative impact of bad loans on the financial institution’s net worth, which is equity value, is the primary reason why lenders make a big deal about credit risk. Why? Ultimately, the financial strength and health of the financial institution are captured primarily by how much equity it has relative to the riskiness of its assets. If its equity goes below the regulatory threshold, the bank is going to be in trouble and will face imminent closure or some type of required restructuring.
As was told in the beginning, the risk is taken with an expectation to receive profits that are greater than costs. The bad news is that bad debt losses are inevitable. The good news is that there are practical steps the lender can take to reduce the risk of bad debt write-offs. To maximize their profits by extending credit only to borrowers who are most likely to pay and reduce their losses by not providing credit to those who may default on their loans, banks need to carefully assess credit risk.
Lenders pay special attention to risk assessment when granting loans to both individuals and legal entities. Risk specialists need to have complete and high-quality information about borrowers to conduct an analysis of the borrower’s creditworthiness in order to make a decision on granting a loan, as well as to respond promptly to the financial problems of the borrower. Thanks to the use of credit scores, the bank is able to reduce the number of “bad” loans by filtering the flow of client loan applications.
Financial entities along with legal institutions developed numerous methods of protecting against credit risks. Among them:
- running a credit check on the borrower
- asking for a business plan
- requesting the company’s financial statement for evaluation
- asking for an employment letter and/or credit reference
- limiting loan amounts to one borrower
- diversifying the forms and terms of loans
- increasing the level of interest
- creating special reserve and insurance funds against non-payment
- thorough preliminary study of the borrower’s solvency
- requirement of guarantees and loan collateral
- insurance of loans and deposits in specialized insurance institutions.
Lenders need to always keep in mind that the best time to manage risk is when they are evaluating a credit application.