Credit Risk Basics
Credit risk is the possibility for a loss to occur due to the failure of a borrower to meet its contractual obligation to repay a debt. For example, a homeowner may stop making mortgage payments. This is also called ‘default risk’ or ‘counter-party risk’, and pertinent credit events may include bankruptcy, failure to pay, loan restructuring, loan moratorium, or accelerated loan payments. In the wake of the 2008 financial crisis, numerous major financial institutions experienced severe losses. These were all due to inefficient risk management.
Some other important types of financial risks that an institution faces are:
- Operational Risk: Loss occurred due to a business’ operations i.e. process, human resources, systems, external events. Operational risk also comes about through external events such as political, legal, and fraud risks.
- Market Risk: Risk caused by unexpected changes in market factors such as interest rates, stock prices, commodity prices, and foreign exchange rates. In the following sections of this book, the primary base of credit risk and its analysis will be discussed. This will include understanding what credit risk is, how to identify risk, and mitigating risk from businesses and portfolios.
The 6 C’s of Credit
The evaluation of the loan request by the bank involves the 6 C’s of credit.
- Character (borrower’s personal characteristics such as honesty, attitudes about willingness and commitment to pay debts): Even though the loan is for the business, the person responsible for paying back the loan is the borrower. It is the borrower’s reputation that the bank will be considering. If one have missed payments or defaulted on a loan or declared bankruptcy in the past, it does not disqualify the person from getting a loan. But trying to hide these facts can destroy character in the eyes of the banks.
- Capacity (the success of business): The banks will look at your business’s balance sheet and cash flow statement to see how much a business can afford to borrow. They will also ask for financial statements to see what kind of debt can be handled. Most small business loans tend to be based on the individual’s or company’s ability to repay the loan, not on the cash flow of the business. Loan officers tend to consider loan applications more favorably if: (a) introducing a new product or service with an obvious demand; (b) there is little competition; (c) your market is composed of small independent businesses; and (d) a lower rate of failure in your type of business.
- Capital (financial condition): most banks require that one should put up a percentage of the loan (just as one would for car loans or buying a house), usually 20 percent.
- Collateral: Collateral represents a repayment source in the worst case scenario. Most banks require that the loan be 100 percent collateralized. This means that the business has to have enough collateral to cover 100 percent of the loan amount. If a loan for Rs.50lacs is needed, then a car, equipment, building, and inventory must to possessed that add up to Rs. 50 lacs.
- Conditions (economic condition): The condition and terms of the loan are another factor where the amount needed, time period and purpose are recognized.
- Compliance (laws and regulations)