What is Credit Risk
Credit risk refers to the risk that a borrower may not repay a loan and that the lender may lose the principal of the loan and/or the interest associated with it. The risk that an issuer of debt securities or a borrower may default on its obligations, or that the payment may not be made on a negotiable instrument.
Credit risk arises because borrowers expect to use future cash flows to pay current debts; it’s almost never possible to ensure that borrowers will definitely have the funds to repay their debts. Interest payments from the borrower or issuer of a debt obligation are a lender’s or investor’s reward for assuming credit risk.
Credit risk is the chance that a bond issuer will not make the coupon payments or principal repayment to its bondholders. In other words, it is the chance the issuer will default. Treasury securities are considered free of credit risk, since they are backed by the awe-inspiring power of the U.S. government to collect taxes to meet its obligations or if the government needs money it can just print more. But all other types of bonds entail at least a little credit risk. Typically, the more credit risk a bond entails, the larger its coupon and the higher its yield.
Credit risk refers to the probability of loss due to a borrower’s failure to make payments on any type of debt. In banking, credit risk is a major factor in determination of interest rate on a loan: longer the term of loan, usually higher the interest rate.
Breaking Down Credit Risk
When lenders offer borrowers mortgages, credit cards or other types of loans, there is always an element of risk that the borrower may not repay the loan. Similarly, if a company offers credit to its client, there is a risk that its clients 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 won’t be able to make a claim.
Credit risk is the risk of loss arising from a borrower’s or counterparty’s inability to meet its obligations. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.
Losses can arise in a number of circumstances, for example:
- A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan.
- A company is unable to repay asset-secured fixed or floating charge debt.
- A business or consumer does not pay a trade invoice when due.
- A business does not pay an employee’s earned wages when due.
- A business or government bond issuer does not make a payment on a coupon or principal payment when due.
- An insolvent insurance company does not pay a policy obligation.
- An insolvent bank won’t return funds to a depositor.
- A government grants bankruptcy protection to an insolvent consumer or business.
The majority of a financial institution’s credit risk arises from its lending activities – outstanding loans and leases, trading account assets, derivative assets, and unfunded lending commitments that include loan commitments, letters of credit, and financial guarantees. It also exists in other activities such as acceptances, interbank transactions, trade finance, and retail and investment settlements.
To reduce the lender’s credit risk, the lender may perform a credit check on the prospective borrower, may require the borrower to take out appropriate insurance, such as mortgage insurance, or seek security over some assets of the borrower or a guarantee from a third party. The lender can also take out insurance against the risk or on-sell the debt to another company. In general, the higher the risk, the higher will be the interest rate that the debtor will be asked to pay on the debt. Credit risk mainly arises when borrowers are unable to pay due willingly or unwillingly.
Types of Credit Risk
A credit risk can be of the following types:
- Credit default risk – The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or the debtor is more than 90 days past due on any material credit obligation; default risk may impact all credit-sensitive transactions, including loans, securities and derivatives.
- Concentration risk – The risk associated with any single exposure or group of exposures with the potential to produce large enough losses to threaten a bank’s core operations. It may arise in the form of single name concentration or industry concentration.
- Country risk – The risk of loss arising from a sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk); this type of risk is prominently associated with the country’s macroeconomic performance and its political stability.
Sovereign Credit Risk
Sovereign credit risk is the risk of a government being unwilling or unable to meet its loan obligations, or reneging on loans it guarantees. Many countries have faced sovereign risk in the late-2000s global recession. The existence of such risk means that creditors should take a two-stage decision process when deciding to lend to a firm based in a foreign country. Firstly one should consider the sovereign risk quality of the country and then consider the firm’s credit quality.
Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:
- Debt service ratio.
- Import ratio.
- Investment ratio.
- Variance of export revenue.
- Domestic money supply growth.
The probability of rescheduling is an increasing function of debt service ratio, import ratio, variance of export revenue and domestic money supply growth. The likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity gains. Debt rescheduling likelihood can increase if the investment ratio rises as the foreign country could become less dependent on its external creditors and so be less concerned about receiving credit from these countries/investors.
Counterparty Credit Risk
A counterparty credit risk, also known as a default risk, is a risk that a counterparty will not pay as obligated on a bond, derivative, insurance policy, or other contract. Financial institutions or other transaction counterparties may hedge or take out credit insurance or, particularly in the context of derivatives, require the posting of collateral. Offsetting counterparty risk is not always possible, e.g. because of temporary liquidity issues or longer term systemic reasons.
Counterparty credit risk increases due to positively correlated risk factors. Accounting for correlation between portfolio risk factors and counterparty default in risk management methodology is not trivial.
How Is Credit Risk Assessed?
Significant resources and sophisticated programs are used to analyze and manage risk. Some companies run a credit risk department whose job is to assess the financial health of their customers, and extend credit (or not) accordingly. They may use in house programs to advise on avoiding, reducing and transferring risk. They also use third party provided intelligence (for example, rating agencies like Standard & Poor’s, Moody’s, Fitch Ratings).
Credit risks are calculated based on the borrowers’ overall ability to repay. To assess credit risk on a consumer loan, lenders look at the five C’s: an applicant’s credit history, his capacity to repay, his capital, the loan’s conditions and associated collateral.
Similarly, if an investor is thinking about buying a bond, he looks at the credit rating of the bond. If it has a low rating, the company or government issuing it has a high risk of default. Conversely, if it has a high rating, it is considered to be a safe investment. Agencies such as Moody’s and Fitch evaluate the credit risks of thousands of corporate bond issuers and municipalities on an ongoing basis.
Most lenders employ their own models (credit scorecards) to rank potential and existing customers according to risk, and then apply appropriate strategies. With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa. With revolving products such as credit cards and overdrafts, risk is controlled through the setting of credit limits. Some products also require collateral, usually an asset that is pledged to secure the repayment of the loan.
Credit scoring models also form part of the framework used by banks or lending institutions to grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively. Once this information has been fully reviewed by credit officers and credit committees, the lender provides the funds subject to the terms and conditions presented within the contract.
How Does Credit Risk Affect Interest Rates?
If there is a higher level of perceived credit risk, investors and lenders demand a higher rate of interest for their capital. For example, if a mortgage applicant has a stellar credit rating and a steady income flow from a stable job, he is likely to be perceived as a low credit risk and will receive a low interest rate on his mortgage. In contrast, if an applicant has a lackluster credit history, he may have to work with a subprime lender, a mortgage lender that offers loans with relatively high interest rates to high-risk borrowers.
Similarly, bond issuers with less than perfect ratings offer higher interest rates than bond issuers with perfect credit ratings. The issuers with lower credit scores need to use high returns to entice investors to take a risk on their bonds.
Managing Credit Risk
It is important to formulate and implement a structured credit policy and related processes to manage credit risk. Strategies for credit risk management, including credit policy development and risk monitoring, is the responsibility of business unit and senior management, and the board of directors.
Financial institutions should establish credit limits to control the risk in all credit-related activity. Limits by industry sector, geographical region, product, customer, and country should be specified, along with the approaches to be used for calculating exposures against those limits, and made part of credit policy. Consideration should also be given to the spread across industries or regions as the default of one firm or industry may also affect others. Larger financial institutions might also consider multiple limits for each borrower or borrower group, by product, operational unit, and borrower member so that banking and trading activities of those borrowers or borrower groups creating credit risk can be more adequately monitored. While the trend has been that many financial institutions monitor total exposures in those categories, most have not set maximum limits on those exposures.
Commercial Portfolio Credit Risk Management
Credit risk in the commercial portfolio can be managed based on the risk profile of the borrower, repayment source, and the nature of underlying collateral given current events and conditions. Commercial credit risk management should begin with an assessment of the credit risk profile of an individual borrower or counterparty based on current analysis of the borrower’s financial position in conjunction with current industry, economic, and macro geopolitical trends. As part of the overall credit risk assessment of an obligor, each commercial credit exposure or transaction should be assigned a risk rating and be subject to approval based on approval standards defined in credit policy. Subsequent to loan origination, risk ratings should be adjusted on an ongoing basis as necessary to reflect changes in the obligor’s financial condition, cash flow, or ongoing financial viability. The regular monitoring of a borrower’s or counterparty’s ability to perform under its obligations allows for adjustments to be made that will affect the credit exposure measurement.
Risk rating aggregations should be considered for measurement and evaluation of concentrations within portfolios. Risk ratings are also a factor in determining the level of assigned economic capital and the allowance for credit losses.
To manage the relative risk within the commercial portfolio, many financial institutions utilize participation or syndication of exposure to other financial institutions or entities, loan sales and securitizations, and credit derivatives to manage the size of the loan portfolio and the relative associated credit risk. These activities can play an important role in reducing credit exposures for risk mitigation purposes or where it has been determined that credit risk concentrations are undesirable.
Consumer Portfolio Credit Risk Management
Credit risk management for consumer credit should begin with initial underwriting and continue throughout a borrower’s credit cycle. Consumer and other common attributes to evaluate credit risk. Statistical techniques may be used to establish product pricing, risk appetite, operating processes, and metrics to balance risks and rewards appropriately. Statistical models can be purchased or created that use detailed behavioral information from external sources such as credit bureaus, along with internal historical experience. These models should be validated periodically to assure they continue to be statistically valid and reflect performance of the institution’s customer base, particularly if used for credit scoring. When used, these models will form the foundation of an effective consumer credit risk management process and may be used in determining approve/decline credit decisions, collections management procedures, portfolio management decisions, adequacy of the allowance for loan and lease losses, and economic capital allocation for credit risk.
Mitigation of Credit Risk
Lenders mitigate credit risk in a number of ways, including:
- Risk-based pricing – Lenders may charge a higher interest rate to borrowers who are more likely to default, a practice called risk-based pricing. Lenders consider factors relating to the loan such as loan purpose, credit rating, and loan-to-value ratio and estimates the effect on yield (credit spread).
- Covenants – Lenders may write stipulations on the borrower, called covenants, into loan agreements, such as:
- periodically report its financial condition;
- refrain from paying dividends, repurchasing shares, borrowing further, or other specific, voluntary actions that negatively affect the company’s financial position;
- repay the loan in full, at the lender’s request, in certain events such as changes in the borrower’s debt-to-equity ratio or interest coverage ratio.
- Credit insurance and credit derivatives – Lenders and bond holders may hedge their credit risk by purchasing credit insurance or credit derivatives. These contracts transfer the risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is the credit default swap.
- Tightening – Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30 to net 15.
- Diversification – Lenders to a small number of borrowers (or kinds of borrower) face a high degree of unsystematic credit risk, called concentration risk. Lenders reduce this risk by diversifying the borrower pool.
- Deposit insurance – Governments may establish deposit insurance to guarantee bank deposits in the event of insolvency and to encourage consumers to hold their savings in the banking system instead of in cash.