Credit risk is the risk of non-payment of a loan by the borrower. It is a type of Financial Risk. In other words, we can define it as the risk that the borrower may not repay the principal amount or the interest payments associated with it (or both) partly or fully. This results in the loss for the lender in the form of disruption of cash flows and increased collection costs.
How Does Credit Risk Arise?
It can result from any of the following reasons – poor cash flows of the borrower, making it difficult to pay the interest and the principal amount, rising interest rates in case of floating interest rate loans, change in market conditions, business failure, unwillingness to repay, etc.
To mitigate or reduce it, lenders often perform a credit check on the borrower, take security from the borrower, take a guarantee from the third party, ask the borrower to take required insurance, etc. To select the right way of mitigating credit risk, a proper credit risk assessment is important.
What is Credit Risk Analysis or Credit Risk Assessment?
Its analysis and assessment mean the same. Both these terms are used interchangeably to address the analysis of reasons that might give rise to it.
Its analysis is the method of calculating the creditworthiness of an individual or a business organization. By doing credit analysis, the lender can evaluate the borrower’s overall ability to honor the financial obligation. For assessing the credit risk, the borrower’s credit history, asset-holding, capital, overall financial strength, ability to repay the debt, probability of default by the borrower during the tenure of payment, etc., are some of the important factors to consider.
As a part of ascertaining it, calculation of its default risk (counterparty credit risk) is necessary.
Understanding Credit Risk Ratio
Its ratio is calculated as a percentage or likelihood that lenders will suffer losses due to the borrower’s inability to repay the loan on time. It acts as a deciding factor for making investments or for making lending decisions.
Generally, banks and lenders classify credit risk as high, medium, or low. On the basis of the credit rating model designed for the company’s internal use. Many companies (banks/lending institutions/private lenders) follow the credit rating reports of renowned credit rating agencies.
What is Counterparty Credit Risk?
Counterparty credit risk is the risk that a counterparty (i.e., another party of the contract) will not fulfill the financial obligation mentioned in the contract. It is also known as default risk. High counterparty risk requires a high-interest payment and vice versa.
Based on its assessment, a credit rating is assigned to the borrower. These ratings are assigned by the credit rating agencies like Standard & Poor’s (S&P), Moody’s Investors Services, Fitch Ratings, CRISIL, CARE, etc. A high credit rating denotes high chances of recovery of the loan. A low credit rating denotes that there might be trouble in recovering the loan from the borrower based on his past performance or bad credit risk associated with his name, low credit score, etc. For example, AAA or AA+ rating given by S&P means there is a very low or almost no risk of default. Similarly, D or CCC or CC rating means there is a high risk of default by the borrower.
What is a Credit Risk Transfer?
To understand credit risk transfer, let us first understand the meaning of risk transfer by a simple example. When you buy an insurance policy, you transfer the speculated risk of loss to the insurance company. So, in the event of any unforeseen situation, all the losses will be borne by the insurance company. This is called risk transfer. Similarly, credit risk transfer is a credit risk management strategy whereby the risk is transferred from one party to another. This can be done by taking credit risk insurance, financial guarantee, etc.
Credit risk monitoring has become very important to know the creditworthiness of an individual or an organization. You will find a lot of books on credit risk management that will guide you and explain the different credit risk modeling techniques.