The main aim of credit risk analysis is to quantify the level of credit risk that the borrower presents to the lender. It involves measurable numbers to the level of a borrower’s default.
Understanding Credit Risk
Credit risk is defined as the risk of loss which is a result of the failure by a borrower to repay the principal and interest owed to the leader. The interest payments from the loan is used by the lender to compensate for the risk of potential losses. In a situation where the borrower defaults on his/her obligations, it causes stagnation in the cash flows of the lender.
Carrying out a credit risk analysis helps the lender to know the borrower’s ability to meet debt obligations. To help to shield itself from loss of cash flows and reduce the severity of losses. Thus, borrowers who present a high level of credit risk get charged a high-interest rate on the loan. In order to compensate the lender for the high risk of default.
Lenders in other to check the credit risk of a borrower. Considers various factors commonly referred to as the “5 Cs of Credit”. These comprise of the borrower’s ability to pay creditors. Character, capital, conditions, and collateral. These factors are used by the lender to gauge the characteristics of the borrower. And conditions of the loan to estimate the probability of default. And the subsequent risk of financial loss.
These 5 Cs factors use financial measures. Thus, the lender may analyze documents, like the borrower’s income, balance sheet, credit reports, and other documents that portray the financial level of a borrower.
Factors For Quantify Credit Risk
Probability of default
This is defined as the probability that the borrower will not be able to meet up with the scheduled principal. And interest payments over a specified period, usually one year. The default probability depends on both the borrower’s attitude as well as the economy.
FICO score shows for individuals, and lenders use the score as a guide to decide if they should or should not extend credit. Businesses on the other hand gets their probability implied by the credit rating.
Loss given default
This is defined as the amount of money that a lender will lose when a borrower defaults on his/her debt duty. Even though there is no method for quantifying the loss given default per loan, most lenders calculate loss given default as a percentage of total exposure to loss in the entire loan portfolio.
Exposure at default
This shows the amount of loss that a lender is can get at any point in time, as a result of loan defaults. Financial houses most times use their internal risk tool models to know the level of exposure at default.
At first, the exposure is calculated per loan, and banks use the figure to show the overall default risk for the entire loan. Then as payments are made, the value of exposure at default reduces.
Exposure at default is of the opinion that risk exposure depends on balances that can accrue before default. Although this factor is almost always used with respect to financial houses, the total exposure is a concept for any person with credit.