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Credit risk is a risk of loss of finance when a debtor is unable to reproduce and pay back the borrowed money or goods and services. It arises when borrower expects his future cash outflows to be the source of clearing the debt. It is also known as default. Investor or creditor faces loss arising from a default situation in terms of principal lent, interest, and collection cost incurred by hiring collection agencies.
Types of Credit risks
Credit Default Risk: The risk of loss of payment when it can be considered that a debtor is not capable to pay the debts. This is considered by banks when obligator is 90 days past on any material credit.
Concentration Risk: It is the risk associated with any vulnerability that is potent enough to harm a bank’s general operations or crediting firm’s finance.
Sovereign Risk: When a government denies fulfilling its obligations or promises it guarantees on the loans, this type of credit risk is called sovereign risk. One should consider sovereign risk while lending to a firm in foreign country.
It is a two step procedure in which lender should check sovereign risk quality of the country and credit reputation of the firm.
Evaluating Credit Risk:
Credit risk may be potent enough to disturb a firm’s or banks financial condition; thus it is essential to evaluate and manage it. Various methods are employed for analysis and assessment of credit risk.
Many companies run a separate department to deal with credit risk. Its job is to use the information available from different sources to assess financial stability of the clients and decide whether to provide or extend credit or not. To counsel on avoidance and reduction of risk, they have in house resources or advisory programs. They also employ some third party agencies to provide intelligence on these matters. These agencies, like Standard & Poor’s, Moody’s Analytics, Fitch Ratings, and Dun and Bradstreet work for fee.
Some creditors employ their personal way of ranking their customer’s credit risk or financial stability and decide actions accordingly. For unsecured credits, higher interests are charged. For products like credit cards and overdrafts, credit limits are set. And for some products, security is demanded, which in most cases is property.
Credit score can prove to be of great help to assess credit risk associated with a party. When credit officers and credit committees check and approve the credit scores, only the credit is lent subject to some terms and conditions. What pose maximum credit risk are ‘mega projects’ that involve large investments. This is because such projects are prone to be entangled in schedule delays due to overrunning cost; in other words, debt-trap.
Extenuating Credit Risk:
1. As a measure to mitigate the credit risk, lenders charge higher rates to borrowers with high credit risk and vice versa. This practice is termed as risk-based pricing.
2. Certain conditions called covenants or concordats are added to the formal agreement between credit issuing and receiving party:
- Debtor is required to regularly describe its prevailing financial condition.
- Recipient party is resisted from paying any bonuses, making any further borrowings, purchasing shares etc., which will put a negative impact on company’s financial condition.
- Borrower may have to repay the full loan in certain conditions.
- Purchasing credit insurance and credit derivatives are ways of hedging credit risk in which risk is transferred from lending party to issuing party in exchange for payment.
- It is in creditor’s hands to cut down or blow up credit extensions. The decision whether to reduce amount of credit extended for all borrowers or certain specific ones lies with the creditor. This is known as tightening.
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