This is also called default risk, as it measures the odds that a party to a financial transaction will default or fail to make required payments as scheduled. Understanding how to interpret this concept is important for investors, as it can affect returns for certain types of fixed-income investments. Credit risk analysis aims to take on an acceptable level of risk to advance the lenders’ goals. By balancing the costs and benefits of granting credit, lenders measure, analyze and manage risks their business is willing to accept. As a result, its share price and bond prices plummeted, its credit ratings were downgraded to junk status, and it faced lawsuits and investigations from creditors, regulators, and shareholders. Collateral security is a very important part of structuring loans to mitigate credit risk.
Credit control can be done using various mechanisms and tools, such as credit approval authority, credit limits, collateral requirements, loan loss provisioning, loan review function, audit function, and corrective actions. Capital is often characterized as a borrower’s “wealth” or overall financial strength. Lenders will seek to understand the proportion of debt and equity that support the borrower’s asset base. Elements of credit structure include the amortization period, the use of (and the quality of) collateral security, LTVs (loan-to-value), and loan covenants, among others. They can also use credit derivatives, such as credit default swaps, to hedge against downgrade risk. A long-term and short-term loan may respond similarly to defaults within the chosen time horizon.
Types of Risks in Banking
Risk is the potentiality that both the expected and unexpected events may have an adverse impact on the bank‘s capital or earnings. Risk arises due to uncertainty or unpredictability of the future due to changes in internal and external business environment. Forbearance measures consist of concessions towards a debtor that is
experiencing or about to experience difficulties in meeting its financial
commitments. Where credit acceptance scorecards are used, types of credit risk new models, model
changes and monitoring of model effectiveness are independently
reviewed and approved in accordance with the governance framework
set by the Group Model Governance Committee. Under the Group’s repurchase (repo) policy, the issuer of the
collateral and the repo counterparty should be neither the same nor
connected. The Risk division has
the necessary discretion to extend this rule to other cases where there
is significant correlation.
Conversely, when transacting with a corporate borrower with a poor credit history, the lender can decide to charge a high interest rate for the loan or reject the loan application altogether. Lenders can use different methods to assess the level of credit risk of a potential borrower in order to mitigate losses and avoid delayed payments. Some data sources provide real-time information that helps lenders make more timely credit decisions and respond to changes in an applicant’s financial situation quickly — not only during onboarding, but throughout the customer life cycle. Also, connections to alternative data sources help present a broader picture of creditworthiness. Banks and fintechs can combat this by leveraging technology that provides real-time data and analytics to help stress test, analyze scenarios, and conduct ongoing monitoring.
Fundamentals of Credit
This will have a financial impact on the
amount of net interest income recognised and on internal loss given
default estimates that contribute to the determination of asset quality
and returns. The requirement for collateral and the type to be taken at origination
will be based upon the nature of the transaction and the credit quality,
size, and structure of the borrower. As part of the ‘three lines of defence’ model, the Risk division is the
second line of defence providing oversight and independent
challenge to key risk decisions taken by business management. The
Risk division also tests the effectiveness of credit risk management
and internal credit risk controls. The principal sources of credit risk within the Group arise from loans
and advances, contingent liabilities, commitments, debt securities and
derivatives to customers, financial institutions and sovereigns. Although the board and senior management play a key role in credit risk oversight, the responsibility for credit risk management is spread throughout a financial institution.
Diversification and risk appetite framework are two key components of credit portfolio management. Financial performance, including a borrower’s revenue, profitability, and cash flow, can also influence credit risk. Lenders and investors must analyze a borrower’s financial performance to determine their capacity to meet their financial obligations. Financial institutions can use various tools, such as credit scoring models and collateral requirements, to minimize their exposure to default risk.
How to Measure Credit Risk?
Borrower-specific factors, such as creditworthiness, financial performance, and industry sector, play a significant role in determining credit risk. Each lender will measure the five Cs of credit (capacity, capital, conditions, character, and collateral) differently. Generally, lenders emphasize a potential creditor’s capacity, or the amount of income they have relative to the debt they are carrying. When lenders offer mortgages, credit cards, or other types of loans, there is a risk that the borrower may not repay the loan. Similarly, if a company offers credit to a customer, there is a risk that the customer may not pay their invoices.
If conditions to exit forbearance are
not met at the end of this probation period, the exposure shall
continue to be identified as forborne until all the conditions are met. Non-performing exposures can be reclassified as performing forborne
after a minimum 12-month cure period, providing there are no past
due amounts or concerns regarding the full repayment of the
exposure. A financial institution must establish sound and well-defined credit
acceptance criteria to facilitate an ex-ante evaluation of prospective credits.