CREDIT RISK

Credit risk refers to the risk that a borrower will default on any type of debt by failing to
make payments which it is obligated to do. The risk is primarily that of the lender and include
lost principal and interest, disruption to cash flows, and increased collection costs. The loss
may be complete or partial and can arise in a number of circumstances.
Credit risk arises from lending activities of the bank. It arises when the borrower does not pay
interest and/or instalments as and when it falls due or in case where a loan is repayable on
demand, the borrower fails to make the payment as and when demanded.
Credit risk in banks not only arise in course of direct lending when funds are not repaid, it
also arises in course of issuing guarantees when the funds will not be forthcoming upon
crystallization of the liability.
The credit risk management process consists of :
1.
2.
3.
4.

Credit risk identification

Credit risk measurement
Credit risk monitoring and control
Credit risk mitigation

1. Credit risk identification: Credit risk arises from potential changes in the credit quality
of the borrower. It has 2 components: default risk and credit spread risk or downgrade
risk.
(a) Default Risk: Default risk is driven by the potential failure of a borrower to make
promised payments, either partially or wholly. In the event of default, a fraction of the
obligations will normally be paid. This is known as the recovery rate.
(b) Credit spread risk or downgrade risk: If the borrower does not default, there is still
risk due to worsening in credit quality.

2. Credit risk measurement: Measurement of credit risk consists of:

(a) Measurement of risk through credit rating/scoring: credit rating of an account is
done with primary objective to determine whether the account, after the expiry of
a given period would remain a performing asset i.e. it will continue to meet its
obligations to its creditors including bank and it would not default. So it seeks to
predict whether the borrower will have capability to honour its financial
commitment in future or not.
(b) Quantifying the risk through estimating expected loan losses i.e. the amount of
loan losses that bank would experience over a chosen time horizon and by
estimating unexpected loan losses.

3. Credit risk control and monitoring: Risk taking through lending activities needs to be
supported by very effective control and monitoring mechanism. It can be done by
credit appraisal process, risk analysis process, credit audit etc.
4. Credit Risk mitigation: It is an essential part of credit risk management. This refers to
the process through which credit risk is reduced or transferred to a counter party.
Lenders mitigate credit risk using several methods:

Risk-based pricing: Lenders generally charge a higher interest rate to borrowers who
are more likely to default, a practice called risk-based pricing. Lenders consider factors
relating to the loan such as loan purpose, credit rating, and estimates the effect on yield
(credit spread).

Covenants: Lenders may write stipulations on the borrower, called covenants, into
loan agreements:

Periodically report its financial condition

Refrain from paying dividends, borrowing further, or other specific, voluntary

actions that negatively affect the company's financial position

Repay the loan in full, at the lender's request, in certain events.

Credit insurance and credit derivatives: Lenders and bond holders may hedge their
credit risk by purchasing credit insurance or credit derivatives. These contracts transfer
the risk from the lender to the seller (insurer) in exchange for payment.

Diversification: Lenders to a small number of borrowers face a high degree

of unsystematic credit risk, called concentration risk. Lenders reduce this risk by
diversifying the borrower pool.