Banks – Banking n Finance » Credit Risk

Credit risk is the risk of loss due to failure of a debtor in payment of a loan or line of credit (either the principal or interest (coupon) or both).

Contents
1 faced by lenders to consumers
2 vs. lenders to business
3 is facing businesses
4 people face
5 Risk counterpart
6, the sovereign risk
7 References
8 See also
8.1 Other types of risk
9 External links
  

Front lenders to consumers
Main article: Consumer credit
Most lenders use their own models (Credit scorecards) to classify existing and potential customers according to risk, and then apply appropriate strategies. With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa. With renewables, such as credit cards and overdrafts, risk is controlled through the setting of credit limits. Some products also require security, most often in the form of ownership.

Front lenders to business
Commercial lenders out of the cost / benefits of a loan according to their risk and interest received. But interest rates are not the only method to offset the risk. Safeguard clauses are written into loan agreements that allow the lender some controls. These covenants may:

limit the ability of the borrower to voluntarily weaken its balance sheet for example, through share buybacks or dividend payments, or need for additional financing.
allow for monitoring of debt requiring audits and monthly reports
allow the lender to decide when you can recall the loan based on specific events or when financial ratios like debt / equity, or interest coverage deteriorate.
A recent innovation to protect lenders and bondholders of the danger of default are credit derivatives, most commonly in the form of a credit default swap. These financial contracts allow companies to buy protection against defaults in third part of the seller protection. The protection seller receives a periodic committee (the extension of credit) as compensation for the risk assumed, and in return agrees to buy the debt should a credit event ( “default” ) occur.

The credit scoring models are also part of the framework used by banks or financial institutions providing credit to customers. Sections for commercial and corporate borrowers, these models are usually qualitative and quantitative risk presented different aspects, including but not limited to, operating experience, management, and asset quality, leverage and liquidity ratios, respectively. Once this information has been completely revised by the credit officers and credit committees, the lender provides the funds subject to the terms and conditions outlined in the contact (as shown above).

Companies face
Businesses have a credit risk when, for example, demand up-front cash payment of goods or services. By offering the product or service first and billing the customer later – if a business customer the terms may be quoted as net 30 – the company is taking a risk between delivery and payment.

Significant resources and sophisticated programs are used to analyze and manage risk. Some companies run a credit risk department whose job is to evaluate the financial health of their customers and extend credit (or not) accordingly. Can be used in housing programs to advise on how to prevent, reduce and transfer risk. They also use third party provided intelligence. Companies like Standard & Poor’s, Moody’s, Fitch, and Dun and Bradstreet provide such information for a fee.

For example, a distributor selling its products to distributors with problems can seek to reduce credit risk by tightening payment terms “net 15”, or actually selling fewer products on credit to retailers, or even cut full credit, and require payment in advance. These strategies impact on sales volume but reduce exposure to credit risk and failure to pay back.

Credit risk is not really manageable for very small businesses (ie those with only one or two customers). This makes these companies very vulnerable to defaults, or even payment delays by their customers.

Using a collection agency is not really a tool to manage credit risk, but is an extreme measure closer to a write operation in which the creditor expects a lower yield was agreed after the collection agency has share (if you are able to get anything at all).

People face
Consumers may face credit risk directly and to depositors in banks or investors and lenders. They also may face credit risk when entering into standard commercial transactions by providing a deposit to their counterparty, eg for a large purchase or rental of real estate. Employees of any company will also depend on the ability of the company to pay salaries, and are exposed to credit risk from the employer.

In some cases, governments recognize that an individual’s ability to assess credit risk may be limited, and the risk may reduce economic efficiency, governments can take various actions or legal mechanisms intended to protect consumers in against some of these risks. Bank deposits, in particular, are insured in many countries (for a maximum amount) for individuals, limiting their credit risk to banks and increasing their willingness to use the banking system.

Counterparty risk
Counterparty risk, also known as default risk, the risk that an organization does not pay on a credit derivative, credit default swap, the credit insurance contract or other transaction or when it’s supposed to be. Even organizations that think they have covered their bets by buying credit insurance still face some risk that the insurer may not pay, either due to temporary liquidity problems or long term, systemic issues.

Major insurers are counterparties to the transactions of many, and therefore this is the kind of risk that financial regulators prompted to act, for example, rescue of insurer AIG.

In the methodological aspect, the counterparty risk can be affected by the risk of evil, ie, the risk of various risk factors correlate in the most damaging. Including the correlation between the portfolio risk factors and counterparty default in the methodology is not trivial, see for example Brigo and Pallavicini

The sovereign risk
Sovereign risk is the risk of becoming a government is unwilling or unable to fulfill their loan obligations, or default on loans guarantees.The existence of sovereign risk means that creditors must have a process point of decision when deciding to lend to a company based in a foreign country. First, it should consider the quality of the country’s sovereign risk and then consider the credit quality of the company.

Five macroeconomic variables that affect the probability of sovereign debt restructuring are:

Ratio of debt service
Import coefficient
Investment ratio
Export income gap
Domestic money supply growth
The probability of rescheduling is an increasing function of the ratio of debt service, the import ratio, the variance of export earnings and growth of the domestic money supply. Frenkel, Karmann and Scholtens also argue that the probability of rescheduling is a decreasing function of the rate of investment due to future increases in economic productivity. Saunders said that reprogramming may be more likely if the investment rate increases as the foreign country could become less dependent on foreign creditors and thus be less concerned about receiving credit for these countries and investors.