Credit risk

From Wikipedia, the free encyclopedia

Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both).

Faced by lenders to consumers

Main article: Consumer Credit Risk

Most lenders employ their own models (Credit Scorecards) to rank potential and existing 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 visa versa. With revolving products such as credit cards and overdrafts, risk is controlled through careful setting of credit limits. Some products also require security, most commonly in the form of property.

Faced by lenders to business

Lenders will trade off the cost/benefits of a loan according to its risks and the interest charged. But interest rates are not the only method to compensate for risk. Protective covenants are written into loan agreements that allow the lender some controls. These covenants may:

• limit the borrower's ability to weaken his balance sheet voluntarily e.g., by buying back shares, or paying dividends, or borrowing further.
• allow for monitoring the debt by requiring audits, and monthly reports
• allow the lender to decide when he 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 bond holders from 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 from a third party, the protection seller. The protection seller receives a periodic fee (the credit spread) as compensation for the risk it takes, and in return it agrees to buy the debt should a credit event ("default") occur.

Faced by business

Companies carry credit risk when, for example, they do not demand up-front cash payment for products or services.^[1] By delivering the product or service first and billing the customer later - if it's a business customer the terms may be quoted as net 30 - the company is carrying a risk between the delivery and payment.

Significant resources and sophisticated programs are used to anaylse and manage risk. Some companies run a credit risk department whose job is to assess the financial health of their customers, and extend credit (or not) accordingly. They may use in house programs to advise on avoiding, reducing and transferring risk.^[2] They also use third party provided intelligence. Companies like Moody's and Dun and Bradstreet provide such information for a fee.

For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by tightening payment terms to "net 15", or by actually selling fewer products on credit to the retailer, or even cutting off credit entirely, and demanding payment in advance. Such strategies impact on sales volume but reduce exposure to credit risk and subsequent payment defaults.

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

The use of a collection agency is not really a tool to manage credit risk; rather, it is an extreme measure closer to a write down in that the creditor expects a below-agreed return after the collection agency takes its share (if it is able to get anything at all).

References

1. ^ Principles for the management of credit risk from the Bank for International Settlement
2. ^ Risk management in the enterprise

• Darrell Duffie and Kenneth J. Singleton, Credit Risk: Pricing, Measurement, and Management, 2003, Princeton University Press

See also

• Consumer Credit Risk
• Credit rating
• Default (finance)
• Interest rate risk
• Legal risk
• Liquidity risk
• Market risk
• Distressed securities
• Operational risk
• Volatility risk
• Settlement risk
• Risk modeling
• Concentration risk

External links

• ZETA Services Inc - Providing Credit Risk Solutions and Service for more than 25 years
• Moody's KMV - The Leading Provider of Credit Risk Management ...
• Facts and Figures about Credit loss risks in Europe
• The Risk Management Association - leading industry organisation for credit risk professionals
• http://bis2information.org: Practical articles, on BIS2 and risk modelling, submitted by professionals to help create an industry standard.

Notes on credit risk and banks' concentration risk can be downloaded from nalin.ca: (1) Credit Risk; (2) Concentration risk