As your business grows and you take on more projects, credit becomes an increasingly important part of your operations. When your business applies for a loan, lenders assess your creditworthiness and credit risk before they lend you the funds.
So what is credit risk, and how does it affect your business operations? In this article, we’ll offer insight into what credit risk is and how lenders evaluate your application before extending credit.
What is credit risk?
Credit risk is the chance that a borrower will fail to repay their debt obligations. When lenders issue a loan, they do so under the assumption that the borrower will make all payments on time and in full. However, if a borrower fails to meet their obligations, the lender will incur a financial loss.
What is an example of credit risk?
Suppose a bank lends money to a small business owner for expansion. The loan requires monthly payments over 10 years.
Scenario 1 (Credit risk realized):
The expansion fails, revenue drops, and the business owner defaults on the loan. The bank is now at risk of losing the money it lent out. This is the realization of credit risk.
Scenario 2 (Credit risk mitigated):
The expansion succeeds, and the business owner repays the loan on time, mitigating the credit risk for the bank.
In this example, the bank's credit risk hinges on the success of the business owner's expansion and their ability to make timely loan repayments.
What are the types of credit risk?
The three main types of credit risk are credit default risk, concentration risk, and country risk. However, there are several types of credit risk, each with unique implications. The types of credit risk include:
- Default risk: This is the most common type of credit risk and occurs when a borrower fails to make their loan payments in full or is 90 days overdue on their loan payment.
- Concentration risk: When a lender focuses their lending on a single borrower or one industry, it increases the risk of default or losses. This is because if the borrower or industry experiences a financial setback, then the lender stands to incur losses.
- Country risk: This type of credit risk refers to the risk of doing business in a particular country. This can include political, economic, and regulatory risks that may impede the ability of lenders to recoup their investments.
- Institutional risk: This risk arises when the entity responsible for supervising the contractual relationship between a lender and a borrower experiences a malfunction.
- Downgrade risk: This type of risk occurs when a borrower’s credit rating is downgraded, and their ability to repay the loan decreases.
- Counterparty risk: Counterparty risk is a type of credit risk of default by the counterparty in a derivatives contract.
Measuring credit risk
When lenders assess the risk associated with your loan, they measure it using several factors. These include your credit score, income level, and past loan history. Your credit card score gives lenders important context around how likely you are to pay back the loan.
One popular formula for measuring credit risk that lenders use is:
Credit Risk Score = Default Probability x Exposure x Loss Rate
This is broken down as follows:
- Default probability is a measure of the likelihood that a borrower will default on their loan. This is calculated by reviewing the borrower’s credit score, income level, and past loan history.
- Exposure is the amount of money that the lender stands to lose in the event of a default. This is calculated based on the size of the loan, the terms, and any collateral provided.
- Loss rate is the percentage of money the lender cannot recoup if a borrower defaults on their loan.
What are the 5 C’s of credit risk?
The 5 C's of credit are another common framework used by lenders to evaluate the creditworthiness of potential borrowers. The 5 C’s are as follows:
- Character: This refers to a borrower's reputation and track record regarding financial obligations. Lenders often perform a credit analysis and look at personal references to gauge a borrower's credit quality and willingness to repay debts.
- Capacity: Credit officers assess a borrower's ability to repay a loan by comparing income against recurring debts and assessing the borrower's debt-to-income ratio.
- Capital: Lenders also consider any capital the borrower puts toward a potential investment. A large contribution by the borrower will lessen the chance of default.
- Collateral: Collateral includes assets, like real estate or a car, that can secure the loan. Lenders will perform a collateral valuation and may offer better terms if the loan is secured against valuable assets.
- Conditions: This refers to the economic and industry conditions at the time of the loan, which could affect the borrower's ability to repay the loan.
What is credit risk management?
Credit risk management refers to the methodology that financial institutions use to evaluate credit risk from potential borrowers in their loan decision-making process. The Basel Committee sets regulatory standards that commercial banks can use to assess risk.
This involves credit scoring models designed to minimize the likelihood that a borrower will default on their loan payments, including assessing a borrower's creditworthiness and liabilities, monitoring loans closely, and ensuring that borrowers make payments on time.
Financial risk analysis
Financial risk analysis involves assessing a borrower’s ability to repay the loan, including their current financial health, future cash flow projections, and credit history. This risk measurement helps lenders decide whether or not to approve the loan.
Credit risk assessment
This involves credit risk modeling to evaluate the borrower’s probability of default and any additional risks associated with the loan. This includes assessing factors such as market volatility, competition, and liquidity. Lenders also look at their internal policies and procedures to determine the risk associated with a loan.
Monitoring
Lenders must also monitor loans closely to ensure they get paid on time and in full. This includes regular contact with the borrower and, if necessary, taking action to recover past-due payments.
There are several methods used to manage credit risk. These include:
- Portfolio management: Loan issuers spread out their investments across different industries and borrowers to minimize potential credit losses in the event of borrower default.
- Collateral: Creditors can require the borrower to provide collateral such as property or other assets to secure a loan. This provides an additional source of repayment in case the borrower defaults on their obligations.
- Risk-based pricing: Lending entities charge different interest rates based on the risk associated with the loan. Higher-risk loans will typically have higher interest rates than lower-risk loans.
- Guarantees: Lenders can also require the borrower to provide a guarantor to back up their loan payments in the event of default.
Impact of credit risk
Credit risk can impact your business, as well as financial institutions and the greater economy. As a business owner, a high risk profile can result in less favorable interest rates, lower credit limits, or being disapproved for loans.
Effective credit risk management is important for mitigating these impacts and ensuring the long-term viability and success of your business.
Ramp: Your partner in credit risk management
At Ramp, our powerful analytical tools help you understand your credit risk and provide in-depth insights into your financial statements.
Plus, our monitoring features help you stay on top of loan repayments and manage the risk associated with your credit portfolio.
Get started today and experience the power of Ramp in your credit risk management strategy.
