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CREDIT RISK

Understanding credit risk is vital to maintaining financial stability and fostering trust in lending relationships. This section explores the key components of credit evaluation—from identifying potential risk exposures to the origination and underwriting of credit. Whether you’re a financial institution or a business extending credit, mastering these fundamentals helps reduce default rates and improve decision-making in today’s competitive credit environment. Dive in to strengthen your credit risk management strategies.

Credit Risk

Credit risk management is the procedural mechanism of detecting, evaluating, and mitigating the probable risk of financial loss stemming from a borrower’s default to repay a debt. It entails assessing a borrower’s creditworthiness, establishing suitable credit terms, and monitoring behavioral pattern to minimize the risk of default. Effective credit risk management is vital for financial institutions and businesses to sustain financial profitability and stability. Credit risk comprises of these two components:

  • Default Risk:measured by evaluating the borrower’s capacity and the willingness to service the debt under the terms of the loan agreement; and
  • Loan Recovery Prospects: The lender ascertains expected loss based on the default risk, and the loan structure and collateral value held.

Expected Loss = EAD x LGD x PD

Where:

  • EAD = Exposure at default
  • LGD = Fraction of the loan amount lost given default (%)
  • PD = Probability of default (%)

Exposure at Default (EAD)

EAD is vital credit risk metric referred to as the potential loss a bank or financial institution could encounter if a counterparty defaults. It computes the total amount likely drawn down on a facility at the time of default, encompassing both the current utilization and a portion of the undrawn balance. EAD is used compute risk-weighted assets (RWA) and calculate potential losses.

  • Exposure at Default (EAD) = Exposure + CCF x (Unutilized Limit).
  • Exposure: refers to the current outstanding balance or utilization of a credit line.
  • Credit Conversion Factor (CCF): is a percentage that calculates how much of the undrawn portion of a credit line will be utilised before default.
  • Unutilised Limit: is the difference between the total credit limit and the current outstanding balance.

Loss Given Default (LGD)

LGD is the fraction of a loan amount lost when the borrower defaults. It is the proportion of the loan’s exposure at default (EAD) that is not recovered after the eventual default. LGD is usually expressed as a percentage or a decimal between 0 and 1, where 0 means full recovery and 1 means total loss.

  • Loss Given Default = 1 minus the recovery rate (LDG = 1 – Recovery Rate).

Or

LDG = Loss / EAD

  • Recovery Rate:It is the percentage of the EAD that is recovered through liquidation of collateral or other means after default.

 

Factors Impacting Probability of Default

  • Borrower-specific factors:Financial health, business model, management quality, and leverage. 
  • Economic conditions:Recessions or economic downturns can rise default rates. 
  • Industry factors:Certain industries are intrinsically riskier than others. 

Macroeconomic factors: Interest rates, inflation, and aggregate economic growth can influence PD. 

  • Probability of default (PD) = (Number of Defaults) / (Total Number of Borrowers).
  • Cumulative Default Probability

This deems the probability of default over a period (e.g., by year t). It can be computed using the formula: P(t) = 1 – e^(-λt), where λ is the hazard rate (intensity of default) and t is the time.

  • Marginal Probability of Default

This is the probability of default in a determined interval (e.g., a specific year) given the borrower has survived up to that point.

  • Annualized Default Rate

This is used to express the default probability on an annual basis, particularly when dealing with discrete intervals. 

  • Credit Default Swap (CDS) Spread

A Credit Default Swap (CDS) spread referred to as the cost of insuring against the default of a debt instrument, characteristically expressed as a percentage of the hypothetical amount. It is significantly the annual fee an investor pays to insure against a particular entity defaulting on its debt. A higher CDS spread suggests a greater perceived risk of default by the reference entity.            

  • The basic relationship is: S = p * (1 – R).

Where S is the CDS spread, p is the probability of default, and R is the recovery rate.

Credit Origination

The credit origination involves a multi-faceted process a lender employs to assess and approve loan applications, including everything from initial to eventual funding. It involves evaluating a borrower’s creditworthiness, examining information, and eventually deciding whether to grant a loan. The procedure is significant for lenders to manage risk and make sure there is compliance with regulations.

Stages of Credit Origination

  • Application/Inquiry

This initial phase entails gathering fundamental borrower information and financial details and probably encompasses a pre-qualification step to evaluate basic eligibility.

  • Processing of Application

The lender assesses the application, checks information (e.g., cash flows, borrower’s file), and probably requires additional documentation, such as tax returns, earnings and deductions (pay stubs) for a specific period.

  • Underwriting

This phase entails a thorough evaluation of the borrower’s creditworthiness, in addition to scrutinizing their credit history, financial statements, and other vital information.

  • Loan Decision

Based on the underwriting analysis, the lender decides to grant or deny the loan application. Loan decision-making includes evaluating the likelihood that a borrower will default in repayment. Lenders assess different factors to ascertain a borrower’s creditworthiness, as well as credit history, financial health, and behaviour of repayment, to minimise potential losses.

  • Loan Funding

If the loan is granted, the loan is funded , and the borrower gets the loan amount. If the loan application is disapproved, the borrower usually is usually informed the reasons for disapproval from the lenders.

  • Control of Quality

Quality control of credit risk is about establishing procedures and controls to ensure reliability, compliance and accuracy of credit risk management activities, The entails identifying, defining (acceptable level of exposure and areas of concentration, type and sources of credit risk exposure), and measuring credit risk, setting credit appetite, and implementing viable credit risk monitoring and managing strategies throughout the lifecycle of credit.

  • Credit Risk Appetite

Credit risk appetite is referred to as the level and nature of credit risk a company or financial institution is prepared to accept in pursuit of its goals. It is an important component of a company’s general risk management framework, ensuring that credit risks are properly managed within an institution’s capacity and strategy. Credit risk appetite is subject to regular review and adjustments.

  • Loan Servicing

Loan servicing, in the perspective of credit risk, includes managing the loan portfolio after its origination, aiming at minimizing probable losses owing to borrower defaults and other risks. Effective loan servicing is vital for financial institutions as it supports the maintenance of the health of their portfolio, management of risk exposure, and guarantee of profitability.

Credit Underwriting Process

Credit Initiation

Either a borrower initiates a proposal to a lender for a loan, or a relationship manager (or an account manager) discovers a prospective loan customer as part of his sales effort. The process of credit initiation and analysis ensures that loans issued by a lending institution comply with the lender’s enterprise-broad credit policy, guidelines, credit standards, and credit procedures.

The credit policy sets forth the types of loan that are acceptable, the loan motives, tenor (maturity), collateral, structure, and acceptable guarantees. In addition, the credit policy states that policy exceptions must have clear approval of the loan approving authority.

Credit Analysis

Loan underwriting is the process of ascertaining if a loan application is an acceptable risk. A significant goal of the process is to assess the credit risk, which consists of two components: the borrower’s ability to repay the loan and collateral backing the loan.

Lenders usually consider the 5 Cs in credit analysis process: (i) Character (borrower’s past behaviour, reputation, and business dealings), (ii) Capacity (borrower’s ability for repay loan), (iii) Collateral (assets pledged as security for a loan), (iv) Capital (borrower’s financial resources and overall financial strength), (v) Conditions (economic environment and industry conditions).