November 03, 2020

An Introduction to Credit Risk

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An Introduction to Credit Risk

The operation of enterprises in a changing market environment is certainly accompanied by risks associated with uncertainty of circumstances, as well as the possible occurrence or non-occurrence of certain events. Today, we will talk about credit risk. 

Modern banks offer all kinds of loans for individuals and businesses. Today, getting a loan from a bank to finance one’s needs, in general, is not a problem. Rather, the problem lies in the ability to minimize the inevitable risks associated with lending money. 

Credit risk management is the main task of banks and other credit institutions. Untimely, partial or complete non-repayment of the principal, as well as the interest on the loan on time is one of the main reasons financial institutions are experiencing losses.

Definition

Credit risk is a possibility that the entity that borrowed the money will not be able to repay the funds received and that the lender may lose the principal and/or accrued interest. Credit risk is also a possibility that the issuer of debt securities or the debtor will fail to meet its obligations, or that payment cannot be made on the debt instrument.

Credit risk arises from the fact that borrowers expect to use future cash flows to pay off current debts, but in practice, there is no 100% guarantee that borrowers will definitely have the funds to pay off their debts. In banking, it is the main factor in determining the interest rate on a loan: the higher the level of risk, the higher the interest rate, as a rule. The interest payments paid by the borrower or the issuer of the promissory note are the reward for the lender or investor for taking credit risk.

Companies may also be exposed to some credit risk in their transactions with the bank. If a company has a lot of free funds that it deposits in a bank, then if there is a risk of bank liquidation, the company risks losing its deposits partially or completely. There is also an interest rate risk when placing a large deposit with one bank because this bank, realizing that the company is a regular depositor, may not offer a competitive interest rate on a new deposit that the company could get in another bank.

An Introduction to Credit Risk

Credit risk reasons

Among the main reasons for credit risk is the lender’s uncertainty about the solvency and responsibility of the borrower. Failure to fulfill the conditions and going beyond the terms of the loan agreement are possible in the following cases:

  • The debtor is unable to generate the required amount of cash flow. This is due to an unfortunate coincidence of circumstances, as well as economic and political reasons.
  • The lender is not sure about the assessment objectivity of the value and liquidity of the assets of the borrower or a guarantee from a third party.
  • The borrower’s business suffers losses due to common business risks.

Credit risk assessment

This type of assessment is the maximum amount of loss that the financial institutions find acceptable for a certain time period with a pre-calculated probability. Among the common causes of loss is a decrease in the loan portfolio value, which occurs as a result of complete or partial loss of solvency of a large number of borrowers.

This analysis is a rather complex process that focuses on the applicant’s ability and intention to repay the loan. The concept of a quality assessment implies a collection of the most detailed information about borrowers. The borrower’s credit history, financial condition, business perspectives, and the environment are studied. The analysis is carried out in seven basic steps.

  1. Checking the applicant’s justification of the need for a loan.
  2. Dynamic analysis of available financial reports, including those submitted to regulatory authorities for several periods. The tendencies of the company’s activity, assets and liabilities are evaluated. The clarity of its marketing, production, and financial perspective is analyzed.
  3. Study of the budget (plan) of cash flows for the period of borrowing to identify bottlenecks that can interfere with the fulfillment of contractual obligations to the bank or other financial institution.
  4. Predictive modeling and assessment of financial stability indicators in scenarios of extreme changes in the external and internal environment.
  5. Market analysis of the company’s position in the market, identification of key threats from the main competitors.
  6. Assessment of the company’s management effectiveness and similar factors.
  7. Issuance of an opinion on all sections of the analysis and documentation of the justification for issuing or not issuing a loan, taking into account the identified risks.
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Author: Charles Lutwidge

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