The most efficient solution to financial emergencies when they occur is a loan, the demand for credit is on the increase. Credit risk assessment is important as it helps lending institutions lessen the risk factor. Although it’s impossible to know exactly who might violate loan terms, properly assessing and managing credit risk can reduce loss. The course of this article contains the meaning and everything there is to know about Credit risks.
What is Credit Risk?
Credit risk is the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations. Literally, it refers to the risk that a lender may not receive the owed principal and interest. This results in an interruption of cash flows and increased costs for collection.
Although it’s impossible to speculate exactly who might default on obligations, properly assessing and managing credit risk can minimize the severity of a loss.
Types of credit risk
There are two major types of credit risks. They include;
- Concentration Risk
We also know this form of credit risk as industry risk. It refers to the risk that arises from gaining too much exposure to any one industry or sector. For instance, an investor who lent money to battery manufacturers, tire manufacturers and oil companies. These investors are extremely vulnerable to shocks affecting the automobile sector.
- Institutional risk
Institutional risk involves risk associated with the breakdown of a legal structure or of the entity that supervises the contract between the and the debtor. For instance, a lender who gives money to a property developer operating in a politically unstable country. The need to account for the fact that a change in the political regime could suddenly increase the chances and the loss rate.
What factors are used to assess credit risk?
In order to assess the credit risk associated with any credit proposal, the project finance division of the firm first runs an assessment exercise. They evaluate and assess a variety of risks relating to the borrower and the relevant industry.
They access credit risk evaluation by considering;
- The financial position of the borrower. By evaluating the quality of the borrowers financial statement, its financial history and its financial flexibility in terms of the ability to raise capital.
- The borrower’s relative market position and operating efficiency.
- The quality of management. By evaluating the borrowers track record, payment record and financial conservatism.
Industry-specific credit risk is evaluated by considering;
- Certain industrial behaviours. Industrial characteristics like the importance of the industry to the economic growth. Also government policies relating to the industry are also considered.
- The competitiveness of the industry.
- Certain industrial finance, including return on capital employed, operating and earnings stability.
Conclusion
Given the fact that defaulting on loan terms and conditions means bad business for every lending institution. The need to check and balance applicants cannot be overemphasized. Bad or irrecoverable debts means bad business to credit institutions so it is only wise to evaluate proposals before offering credits