This post discusses credit risk and credit risk management. In this post, you will understand the meaning of credit risk and the management of credit risks.

WHAT IS A RISK?

A risk is an uncertain event or condition that positively or negatively affects a project’s objectives. Risk is any unexpected event that can affect a project for better or worse. Risk can affect anything: people, processes, technology, and resources. A risk is an uncertainty that cannot be avoided but can be managed. Managing risk is significant, especially in project management, as the risk can positively or negatively impact a project.

WHAT IS CREDIT RISK?

Credit risk is the possibility that a contractual party will fail to meet its obligations under the agreed terms. Credit risk is the probability of loss due to a borrower’s failure to pay for any debt. Credit risk is the primary financial risk in the banking system and exists in virtually all income-producing activities. Identifying and rating credit risk is the essential first step in managing credit risk effectively. 

Credit risk is also variously referred to as default, performance, and counterparty risks. All these terms fundamentally refer to the same thing. For banks and finance firms, credit risk constitutes the possibility of losses associated with a decline in the credit quality of borrowers or counterparties.

Default arising from the inability or unwillingness of a customer or counterparty to meet commitments to lending trading settlement and other financial transactions. Loss from a reduction in portfolio value, actual or perceived, how a bank selects and manages its credit risk is critically important to its performance over time. Indeed capital depletion through loan losses has been the proximate cause of most institution failures.

CHARACTERISTICS OF CREDIT RISK

The following three characteristics define credit risk: 

1. Exposure – To a party that may default or suffer an adverse change in its ability to perform.

2. This party will likely default on its obligations (the default probability). 

3. The recovery rate (i.e., how much can be retrieved if a default occurs).

The more significant the first two elements (i.e., credit risk exposure and the likelihood), the greater the exposure. On the other hand, the higher the amount that can be recovered, the lower the risk.

Credit risk can be expressed as:

Credit risk = Exposure x Probability of default X (1 – Recovery rate)

FORMS OF CREDIT RISK

credit risk may be in various forms, including:

1. Non-repayment of the interest on loan or loan principal,

2. Inability to meet contingent liabilities such as letters of credit guarantees issued by the bank on behalf of the client,

3. Default by the counterparties in meeting the obligations in terms of treasury operations,

4. Not meeting settlement in terms of security trading when it is due,

5. Default from the flow of foreign exchange in terms of cross-border obligations, and 

6. Default due to restrictions imposed on remittances out of the country.

CREDIT RISK MANAGEMENT

Credit risk management is mitigating losses by understanding the adequacy of a bank’s capital and loan loss reserves at any time. Credit risk management is controlling the potential consequences of credit risk. The process follows a standard risk management framework: identification, evaluation, and management. This process helps a firm identify the cause of a threat, evaluate the risk, and decide on the best way to manage the risk.

COMPONENTS OF CREDIT RISK

There are two significant components of credit risk default and portfolio risks. Default risk is a risk that a borrower or counterparty cannot meet its commitment. Portfolio risk arises from the composition and concentration of a firm’s (e.g., a bank) exposure based on its operations. Internal and external factors (e.g., state of the economy, fiscal deficit size and national financial inclusion) can influence a firm’s credit risk exposure.

INTERNAL FACTORS INFLUENCING A FIRM’S CREDIT RISK EXPOSURE

a business credit risk exposure can be influenced by internal factors, i.e., a firm’s specific features. For example, a bank can manage its internal factors by adopting a proactive loan policy, good quality, credit analysis loan monitoring and sound credit culture.

EXTERNAL FACTORS INFLUENCING A FIRM’S CREDIT RISK EXPOSURE

External factors, including the economy’s state, the fiscal deficit’s size and the level of national financial inclusion, can influence a firm’s credit risk exposure. 

Businesses can manage external factors through:

1. Diversification of loan portfolio,

2. Scientific credit appraisal for assessing the financial and commercial viability of loan proposals,

3. Setting standards and requirements for single and group borrowers,

4. Established a standard for sectoral deployment of funds,

5. Strong monitoring and internal control systems, and

6. Delegation of duty and effective accountability.

PRINCIPLES OF CREDIT RISK MANAGEMENT

The credit risk management principles for banks and higher purchase firms are similar. The principles of credit risk adopted by each business should be sound and well-integrated into the structure and operation of the firm.

Here are sound principles for credit risk management:

1. A bank’s board of directors must take responsibility for approving and periodically reviewing the credit risk strategy,

2. Senior management must take responsibility for implementing the credit risk strategy, and

3. Bank must identify and manage the credit risk of all banking products and activities.

CREDIT RISK MANAGEMENT FRAMEWORK

Regardless of the credit risk management framework adopted by a firm, a sound credit risk management framework should include the following eight components:

1. Policy framework,

2. Credit risk rating framework,

3. Credit risk limits,

4. Credit risk modelling,

5. Credit risk pricing,

6. Risk mitigation,

7. Loan review mechanism, and 

8. Credit audit.

CREDIT RISK RATING FRAMEWORK

A significant technique for measuring and monitoring credit risk for loans other than personal and mortgage loans are the technique of credit risk ratings. A credit risk rating system is a formal process that credit facility providers (e.g., banks and finance companies) use to identify and assign a credit risk rating to credit and loan facilities. It will enable the management to assess credit quality, identify problem loans, monitor risk performance and manage risk levels. Risk ratings are most applied to all loans other than private and residential mortgage and bridge loans.

Credit risk rating should be used for loan pricing to ensure the loan is well priced for the risks. A well-managed risk rating system also gives the board of directors, auditors and regulators the information they can use to assess the overall health of the business portfolio.

A credit risk rating system involves categorising risk associated with an individual loan using a thorough credit analysis that considers market conditions, industry data, and other factors necessary to assess a borrower’s credit quality. Loans are rated using a series of gr graduated ratings representing increased risk. Risk ratings should be applied to all commercial loans.

WHEN SHOULD CREDIT RATING BE CONDUCTED

Risk ratings should be conducted in the following three circumstances: 

1. At the time of application for all new or increased loan facilities,

2. As part of the annual review process, and

3. In situations where new information is considered that may materially affect the credit risk of the loan.

CATEGORISATION OF LOANS

Risk rating involves categorising individual loans based on credit analysis and local market conditions into a series of graduated categories of increasing risk. The scope and scale of the credit risk rating system will depend on various factors, including types of credit products or facilities, repayment duration, and the loan portfolio’s complexity. No single credit risk rating system is best for all credit provided.

In many situations, a system comprised of 6 risk levels of increasing credit risk is appropriate. Under this system, the lowest risk rating (1) is assigned to undoubted borrowers with virtually no risk. The highest risk rating (6) is assigned to borrowers with little or no repayment likelihood. Loans should only be granted for risk ratings of 1, 2 (low risk) or 3 (normal risk). Ratings 4, 5 and 6 are reserved for existing loans where the risk rating has deteriorated since the original approval. Risk rating 4 is a “cautionary” rating assigned to higher-risk loans. Loans in this category should be placed on a “watch list” for increased monitoring. Risk rating 5 is for “unsatisfactory” loans that are impaired.

See my video on Credit Risk and Credit Risk Management: https://youtu.be/kaB-RUnrhlU