Credit risk

In the field of economics , personal and business finance turn out to be one of the fields of greatest interest and at the same time, one of the most complicated in the world today. Today you can hear many different terms related to finance, but many remain misunderstood. Perhaps one of the most mentioned is credit risk , a financial problem that can cause serious problems for investors .

Definition of credit risk

The credit risk is a possibility that exists of a significant economic loss which generally derives from the breach of the obligations that are acquired by any of the parties that sign a contract , in this case, economic. This term is closely related to everything that has to do with companies , finance and banking institutions , but it can also be applied to financial markets and organizations in different sectors.

features

The most important characteristics of credit risk are:

• It is one of the most important indicators with respect to the administrative and financial management that occurs in a given company.
• It implies the variation in the results of the finances that occur in a financial asset or in an investment portfolio.
• It can be filed after business bankruptcy or when defaults are made .
• It is seen as a way to measure the probability that a debtor has to be able to face the creditors , complying with the determined payments.
• It is closely related to the different problems that arise in companies or companies.
• This type of risk is asymmetrically negative so it has a greater amount of values ​​towards the left or middle.

Types

The types of credit risk that exist are the following:

• Business Credit Risk : This is the most common type of risk that is present in businesses and micro businesses . It can be presented when, after the installment sale of a certain product is given , the client does not finish paying the amounts that have been previously agreed. This risk can be avoided through outsourcing of companies that can study potential credit risks posed by customers.
• Credit risk in individuals : the main problem that occurs with regard to the credit risk of individuals is that customers can suffer it even though they are not directly exposed . This happens when, for example, a person works independently and runs the risk of not receiving a salary.
• Credit risk in financial institutions : financial institutions have as their main activity the granting of loans to both physical and financial persons and this causes problems of non – payment to arise . For this reason, it is important that financial institutions can carry out different risk studies on clients and include a series of additional clauses in contracts so that guarantees can cover the debt.
• Retail credit risk : in this case, the risk originates mainly in the financial activities carried out by individuals and SMEs . Any type of financing can be affected in this type of risk, be it credits, mortgages or credits.
• Wholesale credit risk : this is a slightly more complicated type of risk because it must be taken into account that, in the wholesale credit risk, the counterparty risk is also included , which intervenes in all the activities that are had to the funding .

What factors influence credit risk

There are two types of factors that can influence credit risk. In the first place we find the internal factors which will always depend directly on the way the company is administered and on the ability of the executives to manage the company. Among the internal factors we can mention:

• Credit volumes, therefore, the higher the volume, the greater the loss.
• Credit policies . The more aggressive this type of policy is, the greater the risks of suffering a credit risk.
• Mix of credits because the greater the credit concentration present between the companies or sectors, the risk that occurs will also be higher.
• Concentration of the economy , geography , the number of debtors , economic groups and shareholders .

In second place we find the external factors which are not dependent on the administration but rather on the basic macroeconomic balances that can compromise the ability to pay. This type of external factor can be measured through the net losses that occur in loans.

Calculation

To correctly calculate the credit risk, the following formula must be used regardless of the type of credit :

PE = PD × EAD × LGD

Where:

• PD refers to the probability of default which occurs when the debtor does not comply with all its obligations.
• EAD which is the exposure to default . This point is equivalent to the value of the position held at the time the default occurs.
• LGD which is the loss that occurs in the event of default . The acronym for this is found and known in English ( loss given default ). Through it, the bank has the ability to recover a part of the investment depending on the recoverability rate which is expressed as -R and which has a value of 1 -R. In order to find the LGD, you need to follow a different formula:

PE = PD × EAD × (1 – R).

How to manage credit risk

In order to properly manage credit risk, it is necessary to follow the following steps:

• Identification of the main source of risk , which can be done by collecting information.
• Define all the most important variables in order to establish relationships .
• Measurement to later model the risk .
• Construction of a model that has the ability to express the internal dynamics of the situation that produces the risk.
• Design of a hedge that provides the ability to control risk .
• Use of derivative financial instruments .
• Analysis and decision- making, which can be done by studying the customer’s creditworthiness .
• Monitoring of all operations while they are in force in order to anticipate potential difficulties
• Make collections in a timely manner in order to pay off the debt.

Importance

Proper management in terms of credit risk policies is extremely important for businesses as this risk can reach cause a positive impact or negative in them and because it is also the best way to realize the risks in order to assess and study the different economic impacts that may arise. When these situations are not adequately monitored, they can bring a series of structural risks that will cause dangerous financial situations over time that companies will not be able to easily overcome.

Examples

As an example we can mention a buyer who manages to obtain a loan for the purchase of a car acquiring the commitment to return the money that has been loaned to him plus the interest that it generates. In this case, the credit risk is linked to the possibility that this buyer cannot pay his debt due to non-payment.