To most corporate executives, the term risk is not clearly defined. They define it in the same way that Supreme Court Justice Potter Stewart once defined pornography. He said that he does not really know how to define it; he will know it when he sees it. For credit risk to make sense, the definition cannot be left vague and must be clearly defined.
Credit risk is the risk of loss of principal because of a borrower's failure to repay a loan or to meet a contractual obligation. Credit risk originates when a borrower uses future cash flow to pay current debt obligations. Lenders or investors are paid back for assuming the credit risk by interest payments from the borrower or the one issuing the debt obligation. Credit risk is calculated by the potential return of an investment from yields on bonds.
If the perceived risk is high, the rate of interest that the borrower must pay to the lender will also be high. Credit risk is calculated based on the borrower's ability to repay the loan. The lender will calculate the credit risk by taking into account the borrower's assets and the revenue-generating capabilities of the borrower.
Lenders use very sophisticated programs to analyze the credit worthiness of a borrower and in turn manage risk. Many employ dedicated credit risk departments, with the remit of assessing the financial status of their potential customers and analyzing whether to extend credit to them or not. They might utilize their own onsite customized programs and models to advise on the avoiding, reduction and transference of perceived risk. They may also employ third parties who will provide them with intelligence information.
Models called credit scorecards are used to rank and evaluate both existing and potential clients in relation to their risk and then to activate appropriate strategies. With, for example, personal loans or unsecured mortgages, a higher credit risk entails a higher rate of interest being charged by the lender. With products like overdrafts and credit cards where the risk is controllable through credit limits being set, the interest rate would be lower. Many loans require the borrower to put up security, usually in the form of tangible property, in order to minimize the risk.
When granting lines of credit to their customers, banks also use a credit scoring card. For corporations, these models have sections that outline different sides of the risk that could include operating expenses, asset quality, inventory, liquidity ratios and management expertise. Once all the data have been checked by those responsible for doing so, funds can be forthcoming from the lender.
The aim of the credit risk manager is to maximize the bank's risk-adjusted rate of return by maintaining the exposure to credit risk within acceptable limits. Lenders must manage the risks that come with the advancement of credit that are built into their entire portfolio as well as the risk in the individual credits.
For most lending institutions, the obvious and the greatest source of credit risk comes from loans. However, there are other sources throughout a bank's operations where credit risks exist. These areas include trading books and banking books. Banks face credit risks in varying financial instruments, not only in the issuing of loans, such as foreign exchange transactions, financial futures trade financing, interbank transactions, swipes bonds, equities and transaction settlements, to name just a few.
The major source of problems for banks the world over continues to be exposure to credit risk. Supervisors and regulators must be able to learn useful lessons from their past experience. Banks should have the acute awareness of the need to identify, monitor, define, measure and control credit risk as well as making sure that they have sufficient capital to offset those risks and that they are sufficiently compensated for the risks they are carrying.
Credit risk is a lesser issue when the borrower's gross profits on sales are high, since the lender is only running the risk of loss on the relatively small proportion of the accounts receivables. On the other hand, if the gross profit is low, credit risk becomes a real issue.
There are several ways to alleviate credit risk. One of the ways is for the lender to obtain credit insurance on the borrower. Another alternative is to require very short payment terms, so that the credit risk will be for only a minimal amount of time. Another option is to require the borrower to get a personal guarantee from somebody with substantial personal resources.