Credit Risk: Definition, Types, and How to Measure It
Credit risk is one aspect that financial institutions usually consider when someone makes a loan. There is a lot of potential for failure to pay off loans that often occur during the repayment period. This risk can occur due to various factors, including the debtor’s financial capacity and economic conditions that affect their financial capacity.
To prevent this risk from happening, this article will review its definition and how to measure and manage it. Let’s read the explanation to the end!
To understand more deeply about this type of risk more, you should first understand its definition. By financial institutions, credit risk can be interpreted as the potential failure of someone to repay a loan under applicable regulations.
Financial institutions seek to carry out careful analysis through several stages to determine the credit scoring of prospective debtors which serves as a measuring tool to assess the eligibility and magnitude of the risk. Here are some types of this risk.
1. Sovereign Credit Risk
This type of risk relates to the country’s ability to pay off its debts. This potential occurs if a country fails to fulfill its financial obligations or pay its debts. The state must pay interest debt, credit principal, and fines in this credit scheme. Factors that can make a country fail to repay credit are financial problems, a significant decline in economic growth, budget deficits, and an unstable political situation.
2. Corporate Credit Risk
Next is corporate credit risk. This type of risk occurs when a company or business cannot pay back its loan on time or even does not pay at all.
This risk is faced by creditors or capital owners or investors who have invested funds in a company or business. The causes of this credit payment failure are the inadequate ability to generate profits, intense market competition, and unsupportive government regulations that can cause losses to the company.
3 . Retail Customer Credit Risk
This risk is closely related to the inability of individual customers to fail to pay their credit installments at maturity. Usually, customers apply for credit from financial institutions to meet their personal needs. But in this risk, there are no financial results that can provide benefits or income to pay off the credit installments from the loan.
How to Measure the Risk
Now we know the risks that can occur if someone cannot pay their credit. To that end, financial institutions carry out careful credit analysis to prevent this, such as measuring the credit risk of prospective borrowers as an example. The aim is to minimize this risk.
Credit analysis involves assessing several possibilities where the debtor will not be able to repay the loan. In this case, the analysis involves credit history or historical data regarding loan amounts, sources of income, and debt ratios. This credit historical data provides an overview of a person’s or certain parties’ credit records, such as discipline in paying loans, timeliness, arrears, and others.
If the debtor has a bad credit history, they will be at high risk. Conversely, good historical data will have a low risk. Sources of income will also be considered in the credit analysis because borrowers with stable and regular incomes are at a lower risk than borrowers with unstable incomes.
Finally, creditors also consider the ratio or comparison between debt and income. The higher the ratio, the greater the risk will be.
Ways to Manage the Risk
After knowing the definition, types, and how to measure credit risk, you also need to know how to manage it. Usually, these methods are used by financial institutions to minimize the possibility of financial loss due to this risk. Here are 6 ways to manage the risk:
1. Grading Model
Healthy lending has a lower risk of causing problems. Banks need to create a credit grading model in an effort to determine the possibility of default in the future.
In addition, banks can also apply risk calibration or adjustment of risk model parameters to obtain accurate risk estimates and find out the opportunities for any unwanted losses. This method will help ensure that the bank’s credit portfolio is not tied to poor-quality credit.
2. Credit Portfolio Management
Credit portfolio management aims to regulate credit flow so that the focus is not on just one area. The principle of risk diversification in the loan portfolio is carried out by distributing credit to various types of industries, business sectors, and different areas.
If there is a problem in one area, then that problem will not affect the entire credit portfolio. This principle is implemented by banks and aims to reduce or minimize the risk of default on a particular loan or group of borrowers.
Securitization is the process of collecting assets to be used as tradable securities. This step was taken to protect the banking business and reduce potential exposure to certain types of credit. In addition, securitization will provide revenue that can be used for new financing.
Collateral can simply be interpreted as a guarantee given by the debtor as a form of responsibility in the event of default. Debtors will be more disciplined in paying and creditors will have certainty about the repayment of loans by debtors because of the collateral.
5. Cash Flow Monitoring
In some cases, banks experience high credit risk which can potentially limit exposure. Cash flow monitoring ensures that customers can react quickly to rapidly changing situations. This step can reduce problems that occur in cash flow.
6. Recovery Management
Problem loans need to be handled carefully to produce the right credit solution. The bank as a lender, of course, has to estimate credit risk and appropriate countermeasures beforehand if unwanted problems occur. Efficient measures against problem loans can provide solutions and recoveries that are large enough to remedy potential losses.
Reducing can also be done by using financial products that match your credit background. This step also aims to make it easier to pay and avoid default when applying for a loan later. Don’t wait any longer! Only use the Credit Scoring service from AdIns that can help your credit worthiness analysis. Contact us for more information about this state-of-the-art service only for your convenience!