What is Credit Risk?
What is Credit Risk?
Credit risk is a key concern for banks, lenders, and investors. It refers to the possibility that a borrower may fail to repay the borrowed amount or interest as agreed. When a borrower defaults, it can lead to direct financial losses for lenders and investors. This is why banks carefully assess credit risk before approving loans or investments.
How to Quantify Credit Risk
Credit risk is often measured using the Expected Loss (EL) formula:
EL = PD × EAD × LGD
Where:
- PD (Probability of Default): Likelihood that the borrower will not repay
- EAD (Exposure at Default): Total amount outstanding at default
- LGD (Loss Given Default): Portion of the exposure the lender cannot recover
For example, a bank grants a loan of ₹15 crore to XYZ Manufacturing Ltd. If the company later faces financial difficulties and defaults, the bank calculates:
PD (Probability of Default): 100%
EAD (Exposure at Default): ₹15 crore
LGD (Loss Given Default): 40%
Expected Loss = 1 × ₹15 crore × 0.40 = ₹6 crore
Thus, the bank expects a potential loss of ₹6 crore, while the remaining ₹9 crore may be recovered from pledged assets.
Types of Credit Risk
Credit risk can arise in several forms, depending on the borrower and the loan type. Understanding these types helps lenders manage potential losses effectively.
Default Risk: Occurs when borrowers fail to repay interest or principal on time. This can affect loans, mortgages, bonds, or derivatives.
Concentration Risk: Arises when a lender’s exposure is focused on one sector, region, or borrower. Lack of diversification increases the chance of significant losses.
Country Risk: Political or economic instability in a country can prevent borrowers from meeting repayment obligations. Changes in government policy, taxation, or currency controls affect repayment ability.
Downgrade Risk: A borrower’s credit rating may fall due to poor financial performance or rising debt. Downgrades reduce market value, liquidity, and investor interest.
Institutional Risk: Weak governance or insolvency of a financial institution can lead to unfulfilled obligations. Policyholders or lenders may face losses if the institution fails.
The 5Cs of Credit Risk Assessment
Banks often use the 5Cs framework to assess a borrower’s ability to repay:
- Character: Examines honesty and past repayment behaviour
- Capacity: Assesses income, expenses, and existing liabilities
- Capital: Evaluates net worth, investments, and ownership in the business
- Collateral: Considers assets pledged as security
- Conditions: Reviews loan purpose, market conditions, and interest environment
Managing Credit Risk
Effective credit risk management safeguards banks’ profits and capital. It involves assessing, monitoring, and controlling risk strategically.
Credit Analysis and Rating: Banks check a borrower’s income, history, and repayment capacity. They assign a rating to indicate the borrower’s risk.
Credit Pricing: Lenders set interest rates to reflect the risk level. Metrics such as RAROC and EVA help calculate rates that cover potential losses.
Credit Monitoring and Control: Banks track repayments, review financial reports, and detect early warning signals. They use credit limits, collateral, and audits to manage exposure.
Risk Management Strategies: Diversification spreads risk across sectors. Guarantees, insurance, and collateral help mitigate potential losses. Proper pricing balances risk and return.
Causes of Credit Risk
Several factors contribute to credit risk:
Credit Concentration: Lending to a single sector or group increases exposure. For example, a bank focused only on real estate loans faces higher risk during a property downturn.
Credit Issuing Process: Poor assessment at the loan approval stage can increase risk. Lenders must follow clear guidelines and monitor borrowers closely.
Inadequate Credit Assessment: Missing information on the borrower’s collateral, capacity, capital, conditions, or credit history weakens the assessment.
Weak Monitoring: Monitoring ensures repayments and collateral value remain on track. For instance, property value may fall over time, increasing default risk.
Additional Credit Risk Considerations
Credit risk also includes:
- Settlement and pre-settlement risk
- Collateral risk, which can mitigate but not eliminate losses
- Rating downgrade risk, affecting loan market value
Credit risk units in banks regularly perform both qualitative and quantitative assessments. They define credit limits, review internal ratings, and monitor potential default scenarios. Proper assessment begins at project appraisal and continues throughout the loan’s lifecycle.
Conclusion
Credit risk remains a major challenge for banks and financial institutions. Poor management can hurt profitability, reputation, and long-term stability. However, careful assessment, diversification, and monitoring help reduce losses.
Managing credit risk is not just about lending safely. It also protects customer trust and ensures sustainable financial growth. A strong risk control framework builds a more secure banking system and supports long-term profitability.
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