What are the Different Types of Credit Risks

Posted by Decipher Credit on July 23rd, 2020

Credit risk modelling is used to determine the probability of default on a loan. This provides the credit risk related information of a borrower at a particular time. It is important to detect credit risk before loan approval. Otherwise, there can be a risk of default and loss of funds. Credit risk modelling is used for validation to make lending decisions on whether credit to the borrower should be extended or not.

A credit risk analysis model can be based on either machine learning, default probability or financial statement analysis. High credit risk exposes the lender to increased collection costs and disrupted cash flow consistency.

Credit Risk

An individual borrower or a corporate failing to meet debt obligations causes credit risk. High credit risk means that the lender is less likely to receive the principal and interest required to service the debt extended to an individual or corporate borrower. The lender may have to rely on a debt collection agency. There can be a risk of a partial or complete loss. The borrower also uses credit risk to determine the interest rate. When there is a high credit risk, lenders attempt to compensate with a high-interest rate. The lender may also reject the application. Similarly, borrowers with a steady income and good credit history can secure a low-interest rate. Lenders use different methods for credit risk analysis. Credit risk assessment helps in mitigating losses and avoiding delayed payments.

Types of Credit Risk

The following are the three types of credit risk: 

  • Credit default risk
  • Concentration risk
  • Country risk

Credit Default Risk

The borrower’s inability to pay the loan obligation leads to credit default risk. This risk also occurs when the borrower already has 90 days past the due date. The risk may affect loans, securities, bonds, derivatives and all other credit-sensitive financial transactions. A broader economic change can change default risk levels. Any changes in the borrower’s financial situation can change the levels of default risk. Such financial situations include recession or increased competition that can affect the borrower’s ability to pay principal and interest on the loan.

Concentration Risk

Exposure to a single sector or counterparty can lead to concentration risk. This can lead to large amounts of losses that can even threaten the core operations of the lender. A more concentrated portfolio may lead to concentration risk. This type of portfolio lacks diversification. For example, the corporate borrower sells products to one major buyer. This is the reason why there can be high levels of concentration risk. If the main buyer stops working with the corporate borrower, this can lead to a large amount of losses.

Country Risk

A country can also freeze foreign currency payments obligations. This can lead to default on its obligations. This can also lead to country risk. Macroeconomic performance and political stability in the country can cause country risk. This adversely affects its assets’ value or operating profits. When the business environment of a country changes, this affects every single company operating within the country.

Factors Affecting Credit Risk Modelling

Accurately forecasting credit risk helps the lender minimize credit risk levels. The following are the three major factors for credit risk levels assessment: 

  • Probability of Default (POD)
  • Loss Given Default (LGD)
  • Exposure at Default (EAD)

Low risk means more profit.  

Decipher Credit

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Decipher Credit
Joined: May 15th, 2020
Articles Posted: 4

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