Definition of Credit Risk
Credit risk infers to the possibility of a loss emerging from a borrower’s downfall to pay back a loan or meet contractual commitments. Conventionally, it pertains to the risk arising as a result of lenders’ inability to return the owed interest and principal, which impacts the cash flows and increases the cost of assemblage. It’s inconceivable to predict with accuracy that who will default on agreements, but a proper assessment and risk management can help you mitigate such credit risk to a remarkable extent by reducing the stringency of losses.
When any lender extends any kind of loan such as mortgages, credit cards, orother similar loans there is an avoidable risk that the borrower might notpay back the loan amounts. Furthermore, if a company offers such credit to the customer there’s the same risk that the customer will not payback. It also incorporates other related risks such as that the bond issuer may not make payment at the time of maturity and the risk occurring out of the incapacity of the insurance company to compensate for the claim. In a beneficial market, a greater level of credit risk will be correlated with the elevated borrowing cost. Because of this credit risk is evaluated technically to mitigate such risk to a certain level.
How to Measure Credit Risk?
One of the modest ways to calculate credit risk loss is to compute expected loss which is calculated as the product of the probability of default(PD), exposure at default(EAD), and loss given default(LGD) minus one.
Mathematically, it is depicted as follows-
Expected Loss = PD * EAD * (1 – LGD)
- Where, PD= Probability of default
- EAD= Exposure at default
- LGD=Loss given default
Example of Credit Risk
Following are example are given below:
Let us suppose that a bank XYZ Bank Ltd has given a loan of $250,000 to a real estate company. As per bank credibility assessment, the company was rated “A” based on industry cyclicality witnessed.
Let us formulate the expected loss for XYZ Ltd based on the details below:
|Exposure at Default (EAD)||$250,000|
|Probability of Default (PD)||1%|
|Loss Given Default (LGD)||68%|
Expected loss can be calculated by using the formula below:
Expected Loss = PD * EAD * (1 – LGD)
Given, PD= 1%, EAD = $250,000, LGD = 68%
PD = 0.10% * $250,000 * (1 – 68%)
Expected Loss = $800
Types of Credit Risk
Credit risks are the reason why lending institutions undergo a lot of creditability assessments before providing credit. Credit risks can be considerably classified into three types.
- Credit Default Risk: Credit default risk includes those losses which are incurred by the lender when the borrower is incapacitated from returning such amount in entire or when the borrower has exceeded 90 days from the due date but hasn’t made any payment.
- Concentration Risk: Concentration risks are those risks that emerge as a result of substantial exposure to any individual or group because any unfavorable incident will have a probability to impose large losses. It is mainly concerned with any individual industry, company.
- Country Risk:Country risks are such risks that are inferred when a sovereign state halts the payment needs to be made for foreign currency commitments overnight which leads to default. Country risks are primarily influenced by macroeconomic accomplishment. It is also termed as sovereign risk.
Causes of Credit Risk
Credit risks are ingrained in the lending process. Along with the credit, the risk is accompanied. Such risks are more in the case of small borrowers having the most probability of default. The main cause of credit risk lies in the inappropriate assessment of such risk by the lender.
Most of the lenders prefer to give loans to specific borrowers only. This causes credit concentration including lending to a single borrower, a group of related borrowers, a specific industry, or sector.
Credit Risk Mitigation
Institution providing loan must consider the following points to mitigate credit risk, including:
- Risk-Based Pricing: Pricing should be based on the amount of risk undertaken. Lenders can charge a high rate of interest from those who are more likely to default. Such practice can mitigate loss from default to a much extent.
- Covenants: Lenders can inscribe stipulates on the borrower in the form of an agreement called covenants. Such as,
- Periodically reporting the financial status of the borrower.
- Pre-payment in case of an unfavorable change in the borrower’s debt-equity ratio or interest coverage ratio.
- Diversification lenders face a high level of probability in the case of small borrowers where there is an inevitable risk of default. Lenders can mitigate credit risks by diversifying the borrower funding pool.
- Credit Insurance and Credit Alternative: Credit insurance is widely operated to mitigate credit risk. These are contracts that transmit the risk from the lender to the insurer in exchange for payment. The most general form of a credit derivative is a credit default swap.
Uses of Credit Risk
- Credit risk analysis is a type of scrutiny performed to acknowledge the borrower’s ability to payback.
- Credit risks infer the ability of the individual to pay back what he owes; lenders usually perform various assessments to mitigate any loss that would arrive in the foreseeable future.
- Lenders can arrive at a less quantifiable loss probability by proper evaluation of such credit risk to curb the chances of loss.
Some of the advantages are given below:
- A good credit risk management scheme improves the capacity to foresee which helps in the evaluation of the potential risk in every transaction.
- The banks use the credit risks model to examine the degree of lending which can be financed to prospected or new borrowers.
- Credit risk management is used as an alternative to traditional techniques for pricing options.
Some of the disadvantages are given below:
- Risk management can be a very expensive liaison.
- Although there are some quantitative techniques to evaluate credit risk. But such decisions are not accurate as it’s not possible to assess risk completely.
- Generally, lenders apply one rigid model to all mitigation approach, which is wrong.
Nowadays, technical innovations have improved credit risk management. Such techniques have increased the proficiency to measure, identify, and regulate credit risk as a portion of Basel III execution.
This is a guide to Credit Risk. Here we also discuss the definition and How to Measure Credit Risk? along with advantages and disadvantages. You may also have a look at the following articles to learn more –