Updated July 17, 2023
Definition of Default Risk
Default risk (also known as credit risk) is a component of credit risk wherein a probability calculated by the lender to quantify the chance of the borrower failing to honour his obligations towards principal and/or towards interest and it is dependent on various factors such as financial health of the borrower, economic factors affecting the business of the borrower, etc. amongst other things.
Explanation of Default Risk
- Default means inbound or something which is bound to happen in normal circumstances. Risk is the chance of loss. So, basically, default risk is an obvious chance/probability that the borrower would not pay at some point of time.
- This concept is applicable in normal loans provided by bankers as well as bonds issued by the corporates. Lenders/bankers/bond subscribers measure this risk before providing any loan or financing the bonds of the issuer.
- Whenever a loan is forwarded to the borrower, the lender is well aware of the probability of the borrower to miss any payments. This feeling is measured in terms of probability depending on various factors related to the borrower.
- Default risk is another extension of the term “credit risk management”. In case of higher default risk, the lender normally charges a higher rate of interest or asks for a higher quality of collateral security.
Example of Default Risk
As an example, we can consider the example of sovereign risk, which is associated with the government not being able to repay the obligations. Well, sovereign default is the least likely position since the debt is backed by the government. However, in the recent past 2015, Greece is said to have defaulted in repayment of the loan to International Monetary Fund (IMF) missing a repayment of 1.6 Billion Euros. The main reason cited for Greece downfall was structural problems resulting in systematic tax evasions.
Another example for sovereign default is when Argentina defaulted on repayment of instalment of $ 805 million towards World Bank in 2002. It resumed its repayment only after IMF restored its credit line. So, as you can see, default risk is the minimum risk prevailing on types of loans, and all types of borrowers.
Types of Default Risk
A default can be categorized into investment-grade default risk and non-investment grade of default risk.
- Investment-Grade of Default Risk: Such category is applicable only for investment type of loans such as bonds, debentures, etc. Standard & Poor’s, Moody’s, Fitch ratings are some of the prominent rating provider for such category of investments. Triple-A rated categories are the highest quality of investment products with lower default risk. So, default risk is completely linked with the type of rating received. For ratings below triple-B ratings, investors can choose for opting out of the investment plan.
- Non-Investment-Grade of Default Risk: These ratings are provided for junk category of investments yielding a higher rate of interest. Due to higher chances of defaults, the rating agencies provided a lower grade of ratings for such securities or investments. Thus, the rate of interest offered is highest in such case.
Key Factors of Default Risk
Every financial tool has factors for measurement or quantification. However not every factor can be to be evaluated in number. Accordingly, default risk has a few key factors. Some of which are as follows:
- In case the proposed borrower has suffered heavy losses in the recent past (may be due to fire at premises or product not capturing market demand, etc.), the lender may remain cautious in provide funds.
- The lender will also check the financial position of the borrower as presented in the latest audited financial statements. The lender may remain cautious in providing funds if the majority of its funds are blocked-in long-term assets.
- A further weak set of cashflows affect the concerns of the borrower.
- The character standing of the borrower is also considered in case the lender is located within the same city as the principal place of business of the borrower.
- The present macro-economic conditions affecting the business or the product of the borrower is also taken into consideration.
The lender notes down such and many other factors which may hint about the possibility of default risk.
Assessing Default Risk
Assessing default means quantification of the risk on the basis of factors that can be numbered.
- The audited financial statements are most relied upon by the lenders first. The past performance of the company since last 5-8 years is taken in consideration. Such evaluation is made for annual as well recent quarterly results.
- The rating agencies provide information about the loans outstanding of the borrower in different banks or financial institutions. The agencies also report on the due date of payment missed by the borrower in the recent past.
- The reputation of the company in the market also matters in case of funding. Reputation is in the terms the frequency of credit cycle used, inventory turnover, repayment turnover, etc.
- Goodwill of the firm in the market affects the lender. In case the experienced promoters are retired from the firm, the goodwill is affected. However, if the firm demonstrates its capacity within a year of retirement of old promoters, the goodwill is restated easily.
- Borrowers can be a corporate, government company, firm or individual. Default risk is said to be lowest in the case of government company & highest in case of individual borrowers.
Managing Default Risk
In case the borrower suffers default risk, counter measures are taken to substantiate the default risk.
- The rate of interest will increase in case of higher default risk.
- The amount of promoters’ contribution should be much higher than the standard requirement of lending institutions.
- The borrower should present projected financial statements with appropriate cashflows.
- The borrower should demonstrate quick repayment capacity by honouring the payments in time with no delay.
- It should also reduce its investment in long term capital assets.
- Solvency ratios such as current ratio, quick ratio and other key ratios such as debt-equity, cash profits ratio, ROI, etc. should remain strong.
Some of the advantages are given below:
- It forecasts the level of risk retained by the proposed borrower.
- A lending institution can earn a higher rate of interest in case of the high-risk borrower with the strong cash flow position.
- It further helps bankers to earn suitable profits with cautious measures.
- The degree of default risk helps bankers to decide on the value of collateral security to be taken.
- The banker can reduce the probability of risk by asking for guarantors for the repayment.
- It helps to quantify the risk at a certain level.
Some of the disadvantages are given below:
- Factors should as bad goodwill or bad image, lower financial character cannot be quantified in numbers. Thus, these factors are given lower weightage at the time of assessment of default risk.
- Information about the borrower is not easily available & it may cost to obtain a certain set of information.
- The businesses are uncertain, especially the start-ups. Bankers requires stable business profile with the assured market segment.
- Even if the credit rating is strong, every borrower has a minimum chance of default, which cannot be ignored.
Default risk assessment is important for the lending institutions. It quantifies the chances of non-repayment by the borrower. However, default risk cannot provide assurance about whether the borrower will resume the repayment soon & the bankers still possess risk of further default. In case of recurring instances of default by the borrower, the collateral security is invoked by the lender to recover the dues.
This is a guide to Default Risk. Here we also discuss the definition and types of default risk along with advantages and disadvantages. You may also have a look at the following articles to learn more –