Definition of Credit Risk
Credit risk is a risk of loss that results when a borrower defaults on the repayment of a loan or fail to meet contractual obligations. Traditionally, credit risk is the probable risk that a lender may not get back the owed principal along with the interest which brings about cash flow interruptions and increased cost for debt collection. While it's impossible to tell which borrower or customer will default on loan repayment and obligations, assessing and managing risk can go a long way to reduce the severity of loss and write-off. The interest received from the borrower is the reward of the lender for managing credit risk.
What Are the Causes of Credit Risk?
When a lender gives a mortgage, loan or credit card, there is always a risk that the borrower may default on the payment on the loan. Similarly, if a business or company offers its customer credit, there is a risk that customers may default on the payment of the invoice. Now, the question is how a business can assess risk?
How Credit Risk Is Assessed?
Credit risk is estimated or calculated based on the ability of a borrower to repay. To determine the credit risk of a customer, you need to consider the five C's critically; that is, the credit history of the customer, capital, capacity to repay, associated with collateral and the conditions of the loan.
Some companies have created departments to assess the credit risk of existing and future customers. Fortunately, technology has given business the resources to analyze the risk profile of customers. If a customer applies for a loan, the department will review the credit history of the customer. If the customer has a bad credit history, then he has a high risk of default. On the flip side, if he has a good credit history, such a customer is considered a safe investment.
A borrower or company must repay loans and handle its credit obligations by ensuring that it has sufficient cash flow to settle loans in a timely fashion. Otherwise, the borrower may stop providing credit to the company or stop transacting business with the company altogether.
How to Reduce Credit Risk for Small Business
Lenders can reduce or control credit risk in a variety of ways. A common way lenders reduce credit risk is adopting risk-based pricing wherein the lenders' charges customers with a perceived credit risk high-interest rates. Another way is to use covenants, whereby lenders gives conditions to loan repayment. The lender may ask the borrower to report their financial situation periodically or that borrowers must repay the loan in full when and if their debt to equity ratio increases. Another way to reduce or control credit risk is diversification. Diversification can reduce credit risk on the part of lenders. A diversified borrower pool is less likely to default on loan repayment at the same time, so the lender or creditor has a hope of recovery.
Aside from these ways, some firms or lenders also use credit derivatives or credit insurance such as credit default swaps to transfer credit risk to a different firm. More importantly, know your customers! Don't offer credit to customers without carrying out due diligence. Make sure to verify the profile and identity of borrowers before issuing credit.