What is Credit Risk?
Credit Risk refers to the risk of default on a debt that is owed by a borrower. It is the risk that a borrower will be unable or unwilling to repay the borrowed funds or meet their financial obligations. This type of risk is commonly associated with lending money, but it can also arise from other financial transactions, such as the purchase of bonds or other debt securities.
Credit risk is influenced by a variety of factors, including the borrower's credit history, financial strength, and overall ability to repay the debt. Lenders and investors typically use credit scores, financial statements, and other financial metrics to assess the credit risk associated with a particular borrower or investment.
Managing credit risk is an important part of managing financial risk, as the failure of a borrower to repay debt can have significant financial consequences for the lender or investor. Lenders and investors use a variety of techniques to manage credit risk, including diversification of investments, credit analysis, and the use of credit derivatives such as credit default swaps.
Understanding Credit Risk
When lenders offer mortgages, credit cards, or other types of loans, there is a risk that the borrower may not repay the loan. Similarly, if a company offers credit to a customer, there is a risk that the customer may not pay their invoices. Credit risk also describes the risk that a bond issuer may fail to make payment when requested or that an insurance company will be unable to pay a claim.
Credit risks are calculated based on the borrower's overall ability to repay a loan according to its original terms. To assess credit risk on a consumer loan, lenders look at the five Cs: credit history, capacity to repay, capital, the loan's conditions, and associated collateral.
Some companies have established departments solely responsible for assessing the credit risks of their current and potential customers. Technology has afforded businesses the ability to quickly analyze data used to assess a customer's risk profile.
If an investor considers buying a bond, they will often review the credit rating of the bond. If it has a low rating (< BBB), the issuer has a relatively high risk of default. Conversely, if it has a stronger rating (BBB, A, AA, or AAA), the risk of default is progressively diminished.
Bond credit-rating agencies, such as Moody's Investors Services and Fitch Ratings, evaluate the credit risks of thousands of corporate bond issuers and municipalities on an ongoing basis.
For example, a risk-averse investor may opt to buy an AAA-rated municipal bond. In contrast, a risk-seeking investor may buy a bond with a lower rating in exchange for potentially higher returns.
Assessing Credit Risk
There are several ways in which to assess the credit risk posed by another party. A good starting place is to analyze the firm’s financial statements to see if it has sufficient liquidity to remain in business, is well-funded, and has a history of consistent profitability. A further financial investigation is to review its gross margin percentage on a trend line, to see if it is able to consistently maintain a reasonable profit; this is derived from being able to establish and hold reasonable price points, as well as by maintaining significant production efficiencies.
Another way to assess credit risk is to review the history of its senior management team. Ideally, this group should have a record of solid financial performance wherever they have worked, preferably having avoided bankruptcy situations. Any evidence in the business press of having made poor management decisions should be reviewed in detail.
In addition to an investigation of the specific business and its managers, a credit risk assessment can also encompass the characteristics of the industry in which the business is located. Some industries are highly competitive, with low margins and a high dropout rate. They may also be nascent industries where there are too many competitors; a shakeout is likely, which will cause multiple businesses to go bankrupt. The result of a highly competitive industry will be readily apparent when the industry-wide return on capital and profits are low. Also, intense competition is more likely to result in highly variable earnings, especially when product replacement cycles are short.
A final analysis is to buy a credit report from a credit reporting agency that delves into the specific financial performance of the business. It notes any delayed payments, prior bankruptcies, and essentially any issue that might increase its credit risk. Depending on the type of report, it may also include a credit score, which is generated by the credit reporting agency.
Managing Credit Risk
Managing Credit Risk is a multi-step process, but it can broadly be split into two main categories. They are:
- Measuring Credit Risk: Credit risk is measured by lenders using proprietary risk rating tools, which differ by firm or jurisdiction and are based on whether the debtor is a personal or a business borrower.
- In personal lending, creditors will want to know the borrower’s financial situation – do they have other assets, and other liabilities, what is their income (relative to all of their obligations), and how does their credit history look? Personal lending tends to rely on a personal guarantee and collateral.
- On the other hand, commercial lending is much more complex; many business clients borrow larger dollar amounts than individuals. Risk rating a commercial borrower requires a variety of qualitative and quantitative techniques. Categories of qualitative risk assessment include:
- Understanding what’s going on in the business environment and the broader economy
- Analyzing the industry in which the borrower operates
- Evaluating the business itself – including its competitive advantage(s) and management’s growth strategies
- Analyzing and understanding the management team and ownership (if the business is privately owned). Management’s reputation and the owner’s personal credit scores will be included in the analysis.
- The quantitative part of the credit risk assessment is financial analysis. Lenders evaluate a variety of performance and financial ratios to understand the borrower’s overall financial health.
Based on the lender’s proprietary analysis techniques, models, and underwriting parameters more broadly, a borrower’s credit assessment will yield a score. The score may be called several different things. For example, the scores for public debt instruments are referred to as credit ratings or debt ratings (i.e., AAA, BB+, etc.); for personal borrowers, they may be called risk ratings (or something similar). The score itself ranks the likelihood that the borrower will trigger an event of default. The better the score/credit rating, the less likely the borrower is to default; the lower the score/rating, the more likely the borrower is to default.
- Mitigating Credit Risk: Credit risk, if not mitigated appropriately, can result in loan losses for a lender; the losses adversely affect the profitability of financial services firms. Some examples of strategies that lenders use to mitigate credit risk (and loan loss) include, but are not limited to:
- Credit structure: Credit risk can be partially mitigated through credit structuring techniques. Elements of credit structure include the amortization period, the use of (and the quality of) collateral security, LTVs (loan-to-value), and loan covenants, among others. For example, if a borrower is riskier, they may have to accept a shorter amortization period than the norm. Perhaps a borrower will be required to provide more frequent (or more robust) financial reporting. Understanding any collateral security that is available and structuring credit accordingly are paramount.
- Sensitivity analysis: Sensitivity analysis is when a lender changes certain variables in the proposed credit structure to see what the borrower’s credit risk would look like if the hypothetical conditions became a reality. Examples include: Suppose a lender intends to extend credit at a 5% interest rate; they may wish to see what the borrower’s credit metrics look like at 7% or 8% (in the event that rates ever increase materially). It is sometimes called a “qualifying rate.” Perhaps a lender plans to offer a borrower a 10-year term loan; they may wish to see what the credit metrics look like if that loan were instead a 6- or 7-year amortization (in the event that conditions changed and the lender wanted to accelerate the repayment of the loan).
- Portfolio-level controls: Financial institutions and non-bank lenders may also employ portfolio-level controls to mitigate credit risk. Strategies include monitoring and understanding what proportion of the total loan book is a particular type of credit or what proportion of total borrowers are a certain risk score.
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).
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.