Credit risk continues to remain one of the areas of concern for a majority of traditional and new-age lenders. The reasons for this are varied. For example, macroeconomic fluctuations, such as political conflict, recessions, or market instability, can lead to higher default rates. Additionally, new-age lenders often cater to underserved or high-risk segments, increasing the likelihood of defaults.
This makes managing credit risk a persistent challenge for lenders aiming to balance growth with financial stability.
The Indian government, not so long ago, revealed that Indian banks wrote off loans worth Rs 10.6 lakh crore in the last 5 years.
This highlights the need for credit risk management to ensure a sustainable and stable economy. This blog sheds light on what we mean by credit risk and the different types of credit risk financial institutions have to deal with.
What is Credit Risk?
Lenders, banks, non-banking financial companies (NBFCs), and Fintech companies engaged in financial transactions must understand the nuances of credit risk, the possibility of late and default payments, and how they intend to recover debt.
Credit risk is the chance or potential of losing money if borrowers do not fulfil their debt obligations. In short, it is the probability of lenders not able to recover debt from borrowers due to different types of credit risks.
Now, let us understand the types of credit risks.
Types of Credit Risks
Credit risk impacts all the stakeholders in the credit chain including borrowers, lenders, policymakers, and government. That said, the nature of credit risks varies depending on the borrower’s characteristics, the current economic landscape, debt amount, interest rates, regulatory environment, and more.
Here are the most common types of credit risks:
Concentration Risk
Concentration risk occurs when a lender concentrates its lending activities only to specific borrowers, companies, or an industry.
For example, a lending institution which predominantly lends to automobile companies faces a concentration risk since it is heavily reliant on the success of the automobile sector. Additionally, lenders may potentially lose their money if the sector is going through a rough patch or experiencing financial stress.
This scenario can be compared to that of an investor who is at risk of losing their investment if they invest in a single bond or investment tool. Therefore, lenders need to diversify their lending portfolio to maintain a steady cash flow and prevent losing money.
Default Risk
Default risk is one of the most common or obvious types of credit risk. As the name suggests, default risk is a type of credit risk all lenders face while lending to the borrowing party.
For instance, if a company does not repay its loan, the lender is at default risk. Default risk is present across all types of credit transactions including mortgages, loans, derivatives, bonds, and more. It is also worth noting that lenders demand a higher interest rate for borrowers with a higher default risk.
Downgrade Risk
Downgrade risk is the risk taken by lenders while lending to a borrower whose credit ratings have taken a hit. For example, CIBIL will lower a company’s or an individual borrower’s credit score if they fail to fulfil their debt obligations.
Institutional Risk
Institutional risk is a type of credit risk that primarily occurs when financial institutions are unable to sustain, are declared insolvent, commit fraud, or are incapable of honouring their promises. Just like concentration risk, institutional risk impacts almost all the stakeholders in the value chain including regulators, creditors, shareholders, investors, and more.
Some of the factors that influence institutional risk include liquidity management, asset quality, compliance, regulatory structure, and more.
Country or Sovereign Risk
Country risk can be defined as the possibility of losing money if the foreign government is unable to repay debt or fulfil its financial obligations due to different factors including political unrest, poor economic conditions and macroeconomic management.
For example, India faces a country or a sovereign risk when another foreign nation is unable to repay the debt taken from India. Additionally, even the performance of local and national banks plays a key role in improving or stabilising the repercussions of sovereign defaults.
Assessing and Managing Credit Risk
As mentioned earlier, credit risk management is detrimental to the financial health of the lender. Therefore, lenders must implement impactful credit risk management practices to mitigate financial losses and maintain steady cash flow.
Some of the most effective risk management techniques include:
Credit Risk Analysis
Credit risk analysis, as the name suggests, is the process of determining the borrower’s creditworthiness by evaluating different financial parameters including cash flow, income, credit score, etc.
Credit Pricing
Credit pricing is one of the most important factors for credit risk assessment. Credit pricing refers to the premium or extra fees in addition to the base rate charged by the lender to mitigate the impact of the assumed credit risk.
Credit Rating
Credit rating is a numerical or alphabetical score assigned to a borrower or a debt instrument depending on their previous track record and credit risk. Credit rating aids in credit risk assessment by bifurcating borrowers into three categories; high, medium, and low risk.
Parting Words
As mentioned before, credit risk impacts all the direct and indirect stakeholders in the lending value chain, particularly when borrowers do not fulfil their debt obligations. It not only hurts the lender’s cash flow but also the overall well-being of the economy.
Lenders must rethink their credit risk management strategies and turn to cutting-edge tools to monitor, control, and mitigate the negative impact of credit risk.
Precisa’s state-of-the-art cloud-based credit report analytics tool offers lenders precious insights into a borrower’s financial health for seamless credit risk management and credit assessment.
Book a free demo today to know more!
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