Credit risk – which measures the credit-worthiness of a borrower – is the possibility of loss, in cases where one or more parties involved in a trade receivable fail to make required payments towards a loan or are unable to meet contractual obligations. Lenders often consider this as the first resort before granting a loan, since there are always risks of the borrower not being able to pay the owed principal and interests, resulting in the disruption of cash flows and increase in the collection cost.
While the losses can sometimes be partial or in many cases complete, higher amount of loan borrowed associates higher levels of credit risk in an efficient market. It is not entirely possible to evaluate exactly who can default on obligations. However, managing credit risks lessens the chances of major losses.
Risk of loss can arise in cases like a borrower being unable to repay the loan to the lender or a customer failing to pay an invoice to the company which offered him credit or a business not paying on-time salary to its employees. Credit risk also refers to bond issuers failing to make payment on requests or insurance company failing to pay a claim.
While every firm have a structural credit approval process, most of them have established a separate departments dedicated to evaluate the credit risks of its current and potential customers.
Assessment of credit risk
The assessment of credit risk is important for a lender to determine the borrower’s ability to pay back the debt. Generally, the credit risk is assessed by keeping in mind the five C’s of a borrower – credit history, capacity to repay, capital, condition of the loan and collateral.
To help financial institutions assess the credit score of a borrower, independent credit bureaus maintain and sell data records of a borrower’s credit repayment history, total debt load and types of credit loans. The amount of credit extended to a borrower and the amount already utilized is also measured. Creditors also calculate borrowers’ income against their living and debt payments to determine whether they can afford a new debt. The asset owned by a borrower to secure a loan, or collateral, is another major factor, as the credit risk lowers if the borrower has more collateral.
However, credit risk can both be borrower credit risk and industry-specific credit risk.
Factors analyzed to assess a borrower's credit risk are:
- The borrower’s financial position
- Past financial performance
- Financial flexibility (ability to raise capital)
- Capital adequacy
- Relative market position
- Operating efficiencies
- Track record, payment record, financial conservatism
Factors analyzed to assess a industry-specific credit risk are:
- Industry characteristics – its importance in economic growth
- Government policies relating the industry
- Industry’s competitiveness
- Industry financials
Buyer credit risk
A buyer’s credit generally refers to a short-term loan provided to an importer by a bank or financial institution for the purchasing of goods or services. Buyer credit risk is one of the biggest credit risks and refers to the risk that a buyer does not make payment towards a trade receivable being financed.
Buyer’s credit risk is assessed considering two major dimensions – ability and willingness.
Lenders usually consider conventional credit metrics, ratios and analysis – like profitability, tangible net worth and cash conversion – to assess the ability of a buyer to repay loans. Usually, lenders tend to finance businesses that can bring-in profit and have a steady cash flow.
The buyer’s willingness to repay loans is mostly assed by his engagement with the supply chain and his track record in financial dealings with suppliers. An understanding of the obligations involved in trade receivable finance and a buyer’s relationship with other financers is also considered while assessing his willingness to repay.
Credit Risk vs Interest rates
The susceptibility of a bond to the changes in the prevailing interest rates refers to interest rate risks; on the other hand, credit risk signifies the chances that a certain amount of principal and interest will not get re-paid. While the bonds with higher interest risks is more liable to perform better when there is a fall in the interest rates, the bonds with higher credit risk tend to perform better if the underlying financial strength improves.
Slower growth signifying fall in interest rates makes rate sensitive securities do better when there is an economic slowdown. Whereas, bonds with high credit risks weakens as their finances deteriorate.
Notably, lenders tend to demand higher interest rates for their capital if there are higher credit risks and may also renounce the investment or loan. Thereby, borrowers with poor credit history often have to deal with subprime lenders, who offer loans with relatively high rate of interests.