Understanding Credit Risk
Credit risk can be defined as the probability of the occurrence of loss on account of the failure of any entity to abide by the contractual obligations. If that was a little technical for your understanding let’s simplify it a bit here; to put it simply credit risk is the risk of loss that might occur if the borrower fails to pay the loan amount. The risk involved here includes lost principal and interest amount, major disruptions to the institution’s cash flows, the huge cost of collection. A borrower failing to repay the loan is just one of the many aspects of credit risks. There are different types of credit risks, such as concentration risk, country risk, etc. Let’s get some clarity into these two different types of credit risk.
Concentration risk can be understood as the risk of loss that might occur when a financial institution or business has limited its operations to some specific industries or businesses. Any economic downturn for that particular industry or business might lead to heavy losses for the financial institutions. It is advised to keep a diversified portfolio to hedge this risk by offering services to businesses across multiple industries.
Country risk is the risk of loss that the financial institution or the lending party might incur when they have operations in a specific country that might not have institutional stability. Country risks can be due to various macroeconomic factors specific to the nation such as political instability or feeble institutions & incompetent regulatory bodies, etc. The changes in the business environment can lead to a reduction in profits for the lending party.
How to calculate Credit risk?
Now that we have established what do we mean by credit risk and two different types of credit risks, let’s see how credit risk is actually calculated. One of the simpler calculations for credit risk is in the form of the expected loss. There are three components to the expected loss formula, the probability of default, exposure amount at default, recovery rate (one minus loss given the default). Let’s take an example to understand this calculation better.
Expected loss = probability of default* exposure at default* recovery rate (1-loss given default (percentage))
Mike borrows an amount of $100000 to start a business. In the next year of its operation due to some macroeconomic challenges, the business failed and Mike was unable to repay the bank. If the loss given default is given as 60% and the probability of default is given as 50% calculate the amount of expected loss.
Probability of default = 50%
Exposure at default = 100000
Recovery rate= 1 - .06 (loss given default) = .40Expected loss = 0.50*100000*0.40 = 20000
What is a Credit rating?
The process of credit rating can be explained as an assessment of the borrower’s profile while lending them credit to, credit rating helps in computing the ability of the borrower to pay back the debt and the probability of loss or degree of loss associated with any specific borrower. Credit ratings are provided to both individual and institutional borrowers. The credit rating agency does a thorough analysis of the borrower’s standing on the basis of the documents provided by the borrower and other relevant non-public information regarding the borrower obtained with the help of analysts.
Credit risk can be summed up as the loss incurred due to the borrower defaulting on his debt commitments to the lending party. There are multiple types of credit risks suck as country risk, concentration risk, etc. A simple way to calculate credit risk is through calculating expected loss which takes into account factors such as the probability of default, exposure amount and recovery rate.