Credit risk is a probability of loss due to a borrower’s failure to make payments on any debt type. Credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. Credit risk means the potential for a bank borrower or counterparty to fail to meet their obligations under agreed terms. Initially, this risk includes loss of principal and interest income, disturbs cash flows, and increases recovery costs. The loss may be complete or partial.
Type of Credit Risk
Credit risk is divided into the following types,
Credit Default Risk
The risk of default occurs due to the borrower who is unwilling to or unable to meet their loan obligations for a period higher than 90 days due to any material credit obligation. Credit Default risk is the probability that a borrower will not pay back extended money from the lender. Calculation of Credit Default Risk is necessary to reduce or manage risk at the time of finance.
Credit Default Risk is changing based on broader economic changes or changes in a company’s or individual’s financial situation because repayment capacity will be reduced in the economic recession. The lender can fix Credit Default Risk by using a credit score based on pricing or limit.
Counterparty risk
Counterparty risk is a type of risk of credit default whereby the counterparty does not pay as obligated on a bond, derivative, insurance policy, or other contracts. This risk is associated with each party as the counterparty will not fulfill its contractual obligation. Counterparty risk is the probability that one of the parties involved in the transaction might default to fulfill its contractual obligation. Counterparty risk is a part of Credit Default Risk, and it is possible in the case of credit, investment, or trading transactions.
Concentration Risk
Concentration Risk describes the risk involved in a bank’s portfolio due to the concentration of a single counterparty, sector, or country. If the credit portfolio is not diversified, then the slowdown of that one sector or collapse of that one counterparty, lender institution may collapse. Therefore, controlling Concentration Risk is necessary with the help of diversification in the lending of funds in each sector.
Country risk (Sovereign Risk)
Country Risk includes the risk that a sovereign state will freeze foreign currency payments (transfer/conversion risk) or a government is unwilling or unable to fulfill its loan obligations or reneging on loans to provide guarantees. This risk is related to the country’s macroeconomic performance and political stability. Country Risk or Sovereign risk is the probability of default of a foreign nation. Various unique risks – currency exchange risk, interest rate risk, price risk, and liquidity risk are associated with Country Risk or Sovereign risk.
Reasons for Credit Risk
Credit Risk occurs due to some of the following factors,
- Inefficient data management: Unavailability of the correct data when required causes problems in lousy decision-making.
- No group-wide risk modeling framework: Banks cannot establish complex and concrete risks without risk modeling and have a broad image of group-wide risk.
- Constant rework: Model parameters are not easily modified any time it creates too much duplication of effort, adversely affecting the bank’s efficiency ratio.
- Insufficient risk tools: Banks cannot define portfolio concentrations or re-assess portfolios regularly to mitigate risk without successful comprehensive risk solutions.
- Cumbersome reporting: Manual, spreadsheet-based reporting systems often overburden analysts and IT departments, which leads to incorrect decision-making.
How to reduce Credit Risk?
Lenders mitigate credit risk in several ways, like
Risk-based pricing
Lenders may charge borrowers who are more likely to default a higher interest rate (such as loan purpose, credit rating, and loan-to-value ratio); this practice is called risk-based pricing.
Covenants
Lenders may write stipulations on the borrower, called covenants, into loan agreements, like the borrower has to report periodically their financial condition, etc.
Credit insurance and credit derivatives
By purchasing credit insurance or credit derivatives, lenders and bondholders may hedge their credit risk (the most commonly used credit derivative is the credit default swap), by which Lenders transfer the risk to the seller (insurer) in exchange for payment.
Tightening
By reducing the amount of credit extended, lenders can reduce their credit risk, either in total or to some borrowers, e.g., banks have a fixed credit lending cap for unsecured advances.
Diversification
Lenders may lend a small amount of funds to different borrowers than a considerable amount to a single borrower. Using this lender diversifies the borrower pools, which reduces lender risk.
Deposit insurance
To guarantee bank deposits, governments may establish deposit insurance in insolvency and encourage consumers to keep their savings in the banking system instead of holding them in cash, which helps lenders identify borrower’s financial capacity.