Credit risk can be defined as the possibility of a bank borrower or a counterparty to fail in fulfilling its obligations as decided according to the terms and conditions. It means that the borrowers might fail to repay the loan and the lender may lose the investment given or interest associated with it.
Credit risks exist because borrower takes the loan in the hope of making enough money in future that would help him repay his loans. It is not possible to be hundred percent sure if the borrower will be able to return the loan in future.
Interest payments that a lender gets from the borrower are lender’s reward for issuing loan despite credit risk. When lenders offer their borrowers mortgages, credit cards and other types of loans, there is always a risk factor involved. Borrowers might never pay the loan.
Likewise, when a company is offering credit, clients may never pay their invoices. Credit risk also refers to the risk that a bond issuer may fail to make a payment when it is requested. For most banks, the most considerable credit risk is involved while issuing loans. However, a risk exists in all sort of activities of a bank including the banking book and trading book.
Assessing credit risk:
Credit risks can be assessed by evaluating the borrower’s overall ability to repay the debt. For the assessment of credit risk on loan, the following five Cs are checked by the lender:
- His capacity to repay
- His capital
- His loan’s conditions
- His credit history
- Associated collateral.
When buying a bond, an investor can look into the credit rating of the bond. If it has a low rating, it shows there is high risk involved. Likewise, if the score is high, it is considered to be a safe investment. Individual companies evaluate the credit risks for bond issuers.
If an investor wants a bond with no credit risk, they might go with AAA rating, or if he doesn’t care much about credit risk, he may buy a bond with higher credit risk that offers a possibility of earning more interest.
The interest taken by the lender is affected by the level of credit risk involved. If there is a higher possibility of credit risk, the higher rate of interest is demanded by lenders and investors.
For example, if an applicant has an excellent credit rating and he has a steady source of income, then he is considered as a moderate credit risk customer and the interest rate put is not so high for him.
Conversely, if the applicant has a bad credit history or no steady source of income, the lender is likely to issue a loan with high-interest rates. It’s is done in an attempt to lower credit risk.
Lenders may also try to reduce the credit risk by asking the banks to report his financial conditions periodically and also keeping him from taking any further loans.
Diversification is also a technique to lower credit risk. If the credit is given to almost same kind of borrowers, there’s a higher risk involved. Lenders reduce the risk by diversifying their borrowers.
Types of credit risk:
Credit default risk:
Credit default risk arises when there is a possibility that a debtor is likely not to be able to pay his loans within the due duration.
It refers to a single or a group of exposure that may produce significant enough losses to affect the bank’s most basic operations.
The risk of loss due to the possibility that a sovereign state may freeze foreign currency payments. This type of risk depends upon country’s economic conditions and political stability.