Credit risk is the probability that a creditor will record losses if a debtor fails to pay . The concept refers to the possible non-compliance with the obligations derived from a financial operation by the person who took the loan.
Credit generally involves the loan of money under certain repayment conditions. Typically, the lender (the party who gives the money) charges interest to the borrower (who receives the amount in question) . For example: if a bank grants a loan of $100,000 with a repayment period of 12 months and an interest rate of 2%, the debtor must return $102,000 after one year (the $100,000 of the loan plus $2,000 in interest) .
In this framework, credit risk is the chance that the lender or creditor will not receive what was agreed upon within the agreed period . The lack of compliance may be partial or total.
Characteristics of credit risk
The notion of credit risk focuses on the possible losses that the entity that grants a loan may suffer . Unlike other risks that affect all the parties in a systematic way, in this case the threat is particularly associated with the situation of the person taking on debt in a specific operation.
When the debtor does not comply with its obligations, it causes losses to the creditor. That is why many times the lender takes out credit insurance that provides coverage and enables them to receive compensation .
Controlling credit risk requires, above all, examining the debtor's payment capacity . The lower the payment capacity, the higher the credit risk.
The analysis
Credit analysis is essential to reduce risk. To avoid non-performing loans , it is necessary to examine the probability of default ( PD ) and make decisions based on that information.
This analysis, ultimately, works as prevention. Evaluating the borrower's creditworthiness requires determining his or her earning capacity. Your credit history is also reviewed.
It is interesting to mention that credit risk can be calculated through a formula. What is done is to estimate the expected loss ( PE ) by multiplying the aforementioned probability of default ( PD ), the exposure at the time of default ( EAD ) and the loss given default ( LGD ), calculating the latter according to the recoverability rate ( 1-R ).
Types of credit risk
According to its characteristics, credit risk can be classified in different ways:
- Risk of non-payment : It is linked to non-compliance with the conditions that were agreed at a financial level.
- Concentration risk : Associated with the distribution of a high amount of liquidity among a small number of debtors; In case of non-payment, serious losses may be suffered.
- Exposure risk : It is related to the uncertainty of upcoming collections due to the instability of the borrower or market conditions.
- Migration risk : It has to do with the devaluation of assets due to a credit rating downgrade.
- Recovery rate risk : Derived from the liquidity risk of the guarantee or the existence of collateral guarantees.
Its reduction
Given that credit risk refers to possible losses for the lender, it is necessary to apply measures to reduce or control it.
As we already indicated, the analysis of the borrower 's payment capacity and solvency is key. This analysis is usually the first step in the procedure that leads to the granting of the loan.
The requirement for guarantees and guarantees is another preventive measure. Beyond taking into account the borrower's ability to fulfill its commitment, the lender must consider how to execute debt collection in the event of possible defaults .
Another resource that reduces credit risk is the diversification of credit portfolios . By lending to actors from different industries or sectors, the risk of exposure to a single type of borrower is minimized.
It is also possible to limit risks through control and monitoring mechanisms. At this point, artificial intelligence ( AI ) can be used for data processing.
Credit risk and scoring
Credit risk can be estimated from credit scoring : obtaining a score that is established based on the history of the person requesting the loan. This score arises from the record of other loans requested, the payment of bills, the use of credit cards and other variables.
In this way, by studying the credit score, an entity can assess the risk involved in granting credit. The score goes from 1 to 999 : the higher it goes, the better the credit rating.
A good credit score is generally considered to be greater than 750 points . This means that if the person requesting a loan has a score of 800 , the credit risk is low. On the other hand, if your credit score is 250 , the lender faces a very high credit risk since there are many possibilities of default.
It should be noted that anyone who aspires to maintain a good credit score or improve it must comply with their obligations without delays , keep their data updated and not request loans frequently. Keep in mind that reversing negative credit reports is complicated because bad scores persist for long periods.