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Global عربي
Credit risk asks a fairly simple question: how likely is it that this borrower won’t pay back their debts? Investors and lenders use it as a quick snapshot to see the likelihood of a loss.
Credit risk is a crucial metric, with knock-on effects that are important for investors and lenders. It can affect interest rates (riskier borrowers require higher rates), influence diversification strategies in a portfolio, and affect overall return on investment. It can determine whether investors buy one security over another.
There are many types of credit risks, but the most common ones to be aware of are the following:
The risk that a borrower will fail to make an interest or principal payment on time.
Example: In 2001, U.S. energy company Enron defaulted on its debt after an accounting fraud scandal. Bondholders and lenders were left with billions in losses.
If someone’s money is concentrated in a single area that may get disrupted in the future, they face concentration risk. In other words, they’re overexposed to a single company, sector, or region, and their financial fate is tied to them.
Example: During the 2008 financial crisis, U.S. banks incurred massive losses because they were heavily invested in subprime mortgages, the values of which collapsed as housing prices plummeted.
The risk that a borrower cannot pay because of political or economic turmoil in their home country, whether an outbreak of war or a sudden currency devaluation.
Example: Lebanon defaulted on its sovereign debt in March 2020, refusing to pay a $1.2 billion Eurobond months after mass protests overthrew its government.
This is the possibility that one party in a deal will fail to make good on their side of a transaction. This can happen with currency exchanges or cross-border payments, especially if the completion of a transaction is delayed because it’s moving through different markets.
Example: In 1974, German authorities shut down Bankhaus Herstatt. The bank collapsed and never delivered U.S. dollars it owed to counterparties even though it had already received Deutsche Marks. This led to settlement losses for banks worldwide.
Read more about: Five Investment Risks Every Investor Should Know & How to Minimize Them.
Credit risk is assessed by calculating various risk metrics. Here are the key ones:
KRIs monitor and attempt to quantify a lender’s exposure to credit risk. They can include things like non-performing loan ratios, credit utilization ratios, and default rates.
Example: A bank’s non-performing loans jump from 1% to 4%, signaling growing credit risk.
This measure how likely it is that a borrower will default on its obligations over a certain time period, typically one year. There are different formulas for calculating PD, but the most common and simple one is:
PD = (Number of Defaults)/(Total Number of Borrowers)
This is how much money a lender expects to lose should a borrower default, after taking into account collateral or guarantees that can mitigate losses. It can be expressed as a percentage of total exposure at the time of default or a single value representing the dollar loss.
- To express as a percentage: LGD = 1- (Recovery Value/Exposure at Default)
- To express as a dollar loss: LGD= Exposure at Default x (1-Recovery Rate)
This is the total expected loss should a borrower default. It includes total outstanding loan balances as well as any amount that a borrower may draw on before defaulting.
EAD= Outstanding loan + Expected Drawdown
This is the difference in yield between two bonds of the same maturity but of different credit qualities. Typically, a riskier bond is compared to a relatively risk-free benchmark, like U.S. treasury bills.
Example: A corporate bond yields 7% and a U.S. treasury bill of the same maturity yields 2%, so the credit spread is 5%, or 500 basis points.
This rates an entity’s ability to fulfil its financial obligations. Independent agencies like S&P, Moody’s and Fitch give credit ratings to companies and governments to assess their ability to repay loans and debts.
1- What is the difference between credit score and credit risk?
A credit score is a numerical value assigned to an individual in order to assess their creditworthiness.
It is based on things like their credit history, payment behaviour and debt utilization. This number is meant to give a snapshot of their overall credit risk, which is the probability that a borrower will not meet their debt obligations.
2-How is credit risk managed in peer-to-peer lending platforms?
Peer-to-peer lending platforms use a variety of tactics to manage credit risk, including:
- Credit assessments: They assess borrowers via credit scores, income verification and debt-to-income ratios, as well as with alternative data like utility or rent payments.
- Risk-based pricing: Higher interest rates are charged to higher credit risk borrowers.
- Diversification: Lenders can spread their investing across many loans, putting small amounts into each.
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3-What is a good credit risk score?
A good credit score implies a low probability of default. What qualifies as “good” depends on the scoring system.
- FICO (300-850 range): A score of 700 or above is considered good. Above 750 is excellent.
Corporate or sovereign ratings: A good credit risk score is investment-grade. With S&P for example, a rating of BBB- or higher is considered good quality, with AAA the highest.
4-Can credit risk be completely eliminated?
No. There is always the possibility of default. But credit risk can be mitigated with tactics like diversification and requiring collateral or guarantees.
5-What is the impact of credit risk on interest rates?
The higher the credit risk, the higher the interest rate. This is because lenders charge a risk premium to compensate for the possibility of a default.
Disclamer:
This post is for educational purposes only, and does not constitute investment advice or a solicitation to take any financial action. It should not be relied upon when making investment or financing decisions.
