What is Credit Risk?
Credit risk is checking the payback nature of a borrower. Lenders often expect that they will recover all of their principal and interest when making a loan. Borrowers that lenders consider to be at a low credit get charged lower interest rates. Lenders and investors consult rating agencies in order to assess the credit risk of doing business with companies.
Understanding Credit Risk
Credit history and credit score: Most credit bureaus maintain records of borrower’s credit. They also check payment history, total debt load. These credit bureaus sell this data to financial houses in order to assess credit risks.
Total debt load: this is how much existing credit has been given to a borrower. As well as how much of that credit has been used. The less credit a borrower has used, the more they are perceived to be able to repay a new loan. Creditors love to see how they can balance it.
Debt-to-income ratio: It’s the amount a person makes against their living expenses and debt payments. Lenders use this to decide if a borrower can afford to take on a new debt payment.
Collateral: Assets owned by a borrower that can be used in securing a loan. The more collateral he has the lower the risk a lender’s faces.
What Factors are Used to Assess Credit Risk?
Often, the project finance division of the firm first assesses different risks. Usually, as it relates to the borrower and the needed industry.
The borrower credit risk can be checked by:
- Firstly, The financial position of the borrower, through the quality of its financial statements, it’s the past financial result, as well as its capital adequacy.
- A borrower’s relative market position and operating strength.
- Lastly, Quality of money spent, past record of money spent, and payment record.
Industry- credit risk is evaluated by:
- Firstly, the importance of the economic growth of the economy and policies.
- The strength of the industry
- Lastly, Certain industry financials, including return on capital employed, operating margins as well as earnings stability.
Challenges to Successful Credit Risk Management
Inefficient data management: This is the inability to access the right data when it is needed which results in delays.
Insufficient risk tools: Where there is no robust risk solution, banks cannot identify portfolio density.
Tiring reporting: When manual, spreadsheet-based reporting processes overburden analysts and IT.