What is Credit Risk?

Credit Risk is the probability of a borrower defaulting on debt obligations. Lenders risk not
receiving the principal and interest component of the debt. This can result in an interrupted cash
flow and increased cost of collection.

Different Types of Credit Risk

• Credit Spread Risk: Credit spread risk is typically caused by the changeability between
interest rates and the risk-free return rate.

• Default Risk: It is a scenario where the borrower is either unable to repay the amount in
full or is already 90 days past the due date of the debt repayment. Default
risk influences almost all credit transactions—securities, bonds, loans, and
derivatives. Due to uncertainty, prospective borrowers undergo thorough background
checks

Downgrade Risk: It is the loss caused by falling credit ratings. Looking at the credit
ratings, market analysts assume operational inefficiency and a lower scope for growth.
It is a vicious cycle; the speculation makes it even harder for the borrower to repay.

• Concentration Risk or Industry Risk: When too much exposure is placed to any one
industry or sector investors, or financial institutions can be at risk for concentration
risk. 

• Institutional Risk: If there is a breakdown in the legal structure, banks may encounter
institutional risk. Institutional risk may also occur if there is an issue with an entity that
oversees the contractual agreement between a lender and debtor. 

• Country risk denotes the probability of a foreign government (country) defaulting on its
financial obligations as a result of economic slowdown or political unrest. Even a small
rumor or revelation can make a country less attractive to investors. The sovereign
risk mainly depends on a country’s macroeconomic performance

How to Access creditworthiness

Lenders will look at your creditworthiness, or how you’ve managed debt and whether you can
take on more. One way to do this is by checking what’s called the five C’s of credit: character,
capacity, capital, collateral and conditions.
1. Character

Character refers to your credit history, or how you’ve managed debt in the past. You start
developing that credit history when you take out credit cards and loans. Those lenders may
report your account history to credit bureaus, which capture it in documents called credit
reports. Then, companies like FICO® and Vantage Score® use the information to calculate credit
scores.

Lenders use credit scores and your credit reports to determine whether you qualify for a loan
or credit. But each lender has different criteria for assessing your credit history. When pulling
your credit reports, they’ll look at the details of your payment history and how much you’ve
borrowed. They’ll also check for things like late payments, foreclosures and bankruptcies.

Lenders may also set minimum credit score requirements. Generally, a higher credit score
signifies less risk for the lender. So maintaining good credit scores or improving your credit
scores may help you qualify for credit in the future.
2. Capacity

Your capacity refers to your ability to repay loans. Lenders can check your capacity by looking at
how much debt you have and comparing it to how much income you earn. This is known as
your debt-to-income (DTI) ratio. You can calculate your own DTI ratio by adding up all your
monthly debt payments and dividing that by your pre-taxed monthly income. Then multiply
that number by 100.

Generally, a low DTI ratio signifies less risk for the lender because it indicates you may have the
capacity to take on an additional monthly debt payment.

3. Capital

Capital includes your savings, investments and assets that you are willing to put toward your
loan. One example is the down payment to buy a home. Typically, the larger the down
payment, the better your interest rate and loan terms. That’s because down payments can
show the lender your level of seriousness and ability to pay back the loan.

Your household income is often the primary source for paying off your loans. But if anything
unexpected happens that could affect your ability to pay them off, like a job loss, capital
provides the lender with additional security.

4. Collateral

Collateral is something you can provide as security, typically for a secured loan or secured credit
card. If you can’t make payments, the lender or credit card issuer can take your collateral.
Providing collateral may help you secure a loan or credit card if you don’t qualify based on your
creditworthiness.

The asset you provide as collateral, and whether you need it, depends on the type of credit
you’re applying for. For auto loans, the car you buy usually acts as collateral. On a secured
credit card, you’d put down a cash deposit to open the account.

Secured loans and secured credit cards are considered less risky for lenders, and they could be
useful for people who are establishing, building or rebuilding their credit.

5. Conditions
Conditions include other information that helps determine whether you qualify for credit and
the terms you receive. For instance, lenders may consider these factors before lending you
money:

• How you plan to use the money: A lender may be more willing to lend money for a
specific purpose, as opposed to a personal loan that can be used for anything.
• External factors: Lenders may also look at conditions outside your control—like how the
economy is, federal interest rates and industry trends—before providing you with credit.
While you can’t control these, they allow lenders to evaluate their risk.

In order to minimize the level of credit risk, lenders should forecast credit risk with greater
accuracy. Listed below are some of the factors that lenders should consider when assessing the
level of credit risk:

• Probability of default
• Probability of default (PD) estimates the probability of borrower's default over a period
of time (normally one year). Default occurs if the borrower is unable to repay its debt to
the bank without forgoing pledged security or the borrower is more than 90 days past
due on material credit obligations. PD is normally calculated based on an assessment of
a range of both qualitative and quantitative factors, often using a bank's borrower
bespoke risk ratings model.
• Loss given default (LGD) estimates the proportion of an asset that it is expected could
be lost when a borrower defaults. It is expressed as a percentage and varies according
to the type and quantum of security or other support available. Unlike PD, LGD is facility
specific rather than borrower specific, which means that an individual borrower could
have multiple facilities each of which would have a different LGD risk profile dependent
on the nature of the facility and the security held.
• Exposure at default (EAD) is the amount to which a bank expects to be exposed to the
borrower at the time of default. It is measured in a currency amount rather than a
probability or proportion, and is equal to the then current amount outstanding. Factors
that affect EAD include facility amount, utilisation and type of facility.
 • Effective maturity (M) is the number of years remaining until the contractual maturity
on a facility.
•
• Expected Loss is the product of PD, LGD and EAD and is effectively a cost of lending.

One of the simplest methods for calculating the expected loss due to credit risk is given below:

Expected Loss=PD×EAD×LGD

Here, PD refers to ‘the probability of default.’ And EAD refers to ‘the exposure at default’; the
amount that the borrower already repays is excluded in EAD. LGD here, refers to loss given
default. If LGD is not given, it is calculated as ‘1 – recovery percentage.’
Credit Risk Example

Let us assume that a bank lends $1000,000 to XYZ Ltd. But soon, the company experiences
operational difficulties—resulting in a liquidity crunch.

Now, determine the expected loss that could be caused by a credit default. The loss given
default is 38%; the rest can be recovered from the sale of collateral (building).

Solution:

Given,

Exposure at default (EAD) = $1000,000

Probability of default (PD) = 100% (as the company is assumed to default the full amount)

Loss given default (LGD) = 38%

The expected loss can be calculated using the following formula:

Expected Loss = PD × EAD × LGD

Expected Loss = 100% × 1000000 × 38%

Expected Loss = $380000

Thus, the bank expects a loss of $380,000.

How to manage Credit Risk

Assess the credit worthiness of customer

• Bank reference
• Trade reference
• Credit rating agencies
• Credit Scores
• Personal Visit
• Financial statement Analysis
• Media Reports
Chase Overdue customers Efficiently

• Monthly reminders
• Chasing through phone/email
• Personal visit
• Apply surcharge on late payments
• Refer to Internal Debt collection Department
• Debt collection agency
• Legal Action
Factoring

To do this, you sell your receivable to a factoring company for its cash value, minus a discount.
This gives you your money immediately because you don’t have to wait for payment—the
customer will pay the factoring company instead of you. But make sure the factoring is on a
“non-recourse” basis, which means you’re not liable if the customer defaults.

Credit insurance

Credit insurance is a type of insurance policy purchased by a borrower that pays off one or
more existing debts in the event of a death, disability, or in rare cases, unemployment. Credit
insurance is marketed most often as a credit card feature, with the monthly cost charging a low
percentage of the card's unpaid balance