One of the most common term used by banks or any financial institution is credit risk. But what’s the big deal about it? Let’s make it simpler. Credit basically is anything taken on loan. When a loan is taken, there’s always a chance or a probability that the borrower or the counterparty may not repay. When he does not repay, there is a risk involved for the lender as he would have commitments based on the amount lent. That’s exactly how credit risk works.
For better understanding, let’s take a normal life example. When we don’t have enough money to meet some of our obligations, say we borrow it from our friends. Based on the trust factor that a friend has with us, he lends us the required sum. Based on when we are going to repay the money back to the friend, he plans his cashflows accordingly. But there is always a probability that we may not repay back the money on time or repay at all. There’s always a chance that we default in the payment. Here is where the risk factor for the friend arises. If we don’t payback, the friend’s cashflows get disturbed and he is going to be exposed to credit risk which is also called credit exposure.
Thus, credit risk is the risk that the borrower or the counterparty will default which leads to disturbances in cashflows for the lender. Since banks entirely work on credit, credit risk is the biggest risk that determine the fate of a bank. Banks collect deposits from customers for which interest is paid and use that money to lend as loans for which they collect higher interest. When banks lend money to borrowers, the probability that he may not repay is the credit risk for the bank. The bank has to take into consideration all factors that would lead to a default and account for the credit risk accordingly. If credit risk is not properly estimated, it would lead to a major liquidity crunch as the banks cashflows depend on repayment by borrowers.
This is why banks do all the background check before lending a credit such as check the credibility, repayment capacity, willingness to repay etc. Willingness to repay here plays a major role as many of the scams that has happened recently is due to this factor. The bank measures all these factors and arrives at a figure of risk for which separate provisions are to be set aside. Since there is a probable default, exposure to such default and a loss involved due to the default, the bank calculates these different terms of Default (PD), Exposure at Default (ED) and Loss Given Default (LGD). These three factors combined together helps the bank calculate expected loss and set aside provisions accordingly.
Special models are used by banks to estimate these probabilities and the credit score of individuals and credit ratings for companies play a major role in such estimation. Banks also estimate recovery rate based on the security or collaterals provided by the borrowers which are included in the expected loss calculation. Credit Risk eventually leads to the next important risk any bank faces which is the liquidity risk. Banks have to undertake proper Asset Liability Management (ALM) where the assets and liabilities of the bank that is the loans and deposits are categorized into various time buckets according to their maturity. If banks do not account for credit risk, the lack of repayment eventually would affect the liquidity which results in a complete haphazard in the bank's revenue.
Credit Risk eventually leads to the next important risk any bank faces which is the liquidity risk. Banks have to undertake proper Asset Liability Management (ALM) where the assets and liabilities of the bank that is the loans and deposits are categorized into various time buckets according to their maturity. If banks do not account for credit risk, the lack of repayment eventually would affect the liquidity which results in a complete haphazard in the bank's revenue.
Thus, credit risk management is a very important aspect that is to be undertaken by all financial institutions where the credit risk is to be properly identified, measured, monitored and mitigated so as to control the occurrence of NPAs. Lower the credit risk, better the profitability of a bank and higher the efficiency.