Understanding credit risk: Types and key factors

What is Credit Risk?
Credit risk arises when a borrower, whether an individual or a company, fails to meet their debt obligations. This risk represents the chance that a lender will not receive the full principal and interest payments owed on a loan. For lenders, credit risk can disrupt cash flows and increase collection costs, as they might need to hire a debt collection agency. The loss incurred can be partial or total, meaning the lender could lose part of or the entire loan amount.
To compensate for this risk, lenders charge interest on loans. In a well-functioning market, high-risk loans come with higher interest rates. For example, a borrower with a strong credit history might secure a loan at a lower rate compared to someone with a poor credit history, who would face higher rates or even a loan rejection.
Types of Credit Risk
Credit Default Risk
Credit default risk occurs when a borrower cannot repay their loan in full or is significantly overdue, typically more than 90 days. This type of risk affects all financial transactions involving credit, including loans, bonds, securities, and derivatives. Factors such as economic changes or shifts in a borrower’s financial situation, like increased competition or a recession, can impact default risk.
2. Concentration Risk
Concentration risk arises when a lender is heavily exposed to a single counterparty or sector, which can lead to significant losses if the borrower or sector faces problems. For instance, if a company relies on one major buyer for its products, it risks substantial losses if that buyer stops purchasing.
3. Country Risk
Country risk involves the risk that a country may freeze foreign currency payments or default on its obligations due to political instability or poor economic performance. This type of risk affects all businesses operating within the country. Changes in the business environment, such as political upheaval or economic downturns, can impact the value of assets and profits.
Factors Affecting Credit Risk Modeling
To manage and minimize credit risk, lenders assess several factors:
1. Probability of Default (POD)
POD is the likelihood that a borrower will default on their loan. For individuals, it is determined by their credit score and debt-to-income ratio. For companies, credit rating agencies provide this probability. A lower POD generally means a lower interest rate and fewer down payment requirements. Collateral can also help mitigate this risk.
2. Loss Given Default (LGD)
LGD represents the amount a lender will lose if a borrower defaults. For example, if two borrowers have the same credit profile but one has a $10,000 loan and the other has a $200,000 loan, the lender faces a higher loss if the latter defaults. LGD is calculated across an entire loan portfolio to gauge overall exposure.
3.Exposure at Default (EAD)
EAD measures the total amount of loss exposure at the time of default. It reflects the lender’s risk appetite and is calculated by adjusting each loan obligation by a specific percentage, based on the details of the loan.