Credit risk is the risk of loss caused by a counterparty’s or a borrower’s failure to make timely payment or caused by the change in the value of a financial instrument based on changes in default (market) risk.
Credit risk arises when a borrower does not pay the amount due willingly or unwillingly.
Causes of credit risk are:-
- Investing in projects without a proper check on the chances of that project succeeding
- No insurance is taken by the borrower to cover up the loss
- Unsuitable market conditions
- Fluctuations in Interest rates
- Poor credit risk management
- Increased collection costs
- Insolvency of the borrower
Credit risk is only faced by a party which has amounts receivable in the future.
Examples of credit risk
- A borrower does not repay the loan amount or interest installments
- A business declared insolvent and did not have enough assets to pay the unsecured creditor
Credit risk can be avoided by proper credit risk management. Two things that help in this are
- Credit risk transfer- this involves transferring the risk from one person to another. For ex: – taking insurance against the borrower’s default
- Credit risk ratio = Monthly recurring debts ➗ Gross monthly income
Types of credit risk
- Credit default risk
- Country risk
- Concentration risk