Before earning interest, lenders must first face one big question: Will the borrower repay? The answer lies in credit risk. It is the uncertainty associated with any loan amount that determines who gets the loan and under what conditions.
In this article, we’ll learn how to find the credit risk and different ways through which we can manage it.
What is Credit Risk?
When a borrower fails to meet his financial obligations, partially or completely, it is known as credit risk. It exists whenever money is lent, regardless of the form of lending.
Suppose a bank lends ₹10 lakh to a business at 9% interest rate for a period of 5 years. If the borrower stops paying after 3 years, the bank will face a loss. This potential loss is the credit risk for the bank.
However, credit risk is not limited to banks only. It affects individuals, businesses, and even governments. The key idea is simple: when repayment is uncertain, risk is present.
Types of Credit Risk
There are several forms of credit risk depending on the borrower, the environment, and the structure of the exposure.
Default Risk
The default risk arises when the borrower fails to partly or fully pay back their debt obligations. It is the most common type. To control the risk, a deep evaluation of potential borrowers is carried out by the lenders.
Example: Rohan takes a house loan of ₹40 lakh at 8% interest rate over 20 years. After 3 years, he loses his job and is unable to continue with the EMI payments. Although the bank recovered a partial amount, it suffered a loss due to the default risk.
Concentration Risk
The concentration risk arises when the lender overexposes itself to a particular borrower, sector, or region. Diversification is helpful, and ignoring concentration can amplify the losses.
Example: A bank has lent ₹500 crore to companies, out of which ₹400 crore is lent to players in the real estate sector. Soon, the housing market crashes, and the borrowers start to struggle to pay back the loans. Even if the borrowers were financially sound, the bank’s risk was elevated due to concentration.
Country Risk
Country risk refers to a situation where borrowers from a specific country can’t fulfill their obligations due to economic crises, political instability, or policy changes. Country risk is especially relevant in emerging markets.
Example: Suppose Aakash bought ₹25 lakh worth of sovereign bonds from Brazil paying 12% interest per annum. Due to the financial crisis and currency devaluation, he doesn’t receive his interest payments on time. The interest rate was lucrative, but Brazil’s environment was not a suitable lending option in this situation.
Downgrade Risk
When the borrower’s credit rating falls, it is called downgrade risk. The downgrade means access to capital becomes harder and higher borrowing costs.
Example: ABC Ltd. issued AA-rated bonds at 7.5% annum. Due to declining profits and higher leverage, the rating fell to BBB over the next two years. This lowered the market value from ₹1,00,000 to ₹92,000 per bond, and investors holding these bonds had to face losses.
Institutional Risk
Institutional risk arises due to a financial institution’s weak internal systems, poor underwriting standards, governance failures, or operational inefficiencies.
Example: A hypothetical institution, JanDhan Bank, has approved car loans worth 50 crore without properly checking the income documents. In case the borrowers are unable to fulfill their commitment, the bank will suffer great losses. Here, the risk is not just due to the borrower but also flaws in the bank’s internal processes.
How to Calculate Credit Risk
Credit risk is calculated with the given formula:
Expected Loss (EL) = PD × EAD × LGD
Where, PD is the borrower’s default probability,
EAD is the Exposure At Default, which means the maximum amount the lender can lose,
And LGD is the Loss Given Default, which determines the percentage of exposure.
A bank lends ₹20,00,000 to a manufacturing firm, and the probability of default is estimated at 5%. The loss given default is 40%, assuming a 60% recovery.
Now, apply the credit risk formula:
Expected Loss = 0.05 × 20,00,000 × 0.40
Expected Loss = ₹40,000
This means the bank can expect an average loss of ₹40,000 from this exposure over time.
Credit Risk Example
Let’s take two hypothetical examples to understand the credit risk:
Case 1: Suppose an investor buys corporate bonds worth ₹10,00,000 at 10% annual interest. After two years, the issuing company faces losses and can not pay back its debt.
The company goes bankrupt, and only 35% of the amount is recovered. The investor receives ₹3,50,000, and the rest, ₹6,50,000, represents their credit risk.
Case 2: A bank issues 1,000 credit cards with an average limit of ₹1,00,000 each. The total exposure is ₹10 crore.
If 8 % of cardholders default and the average recovery is 30%, the loss will be:
Defaulted exposure = ₹10 crore × 0.08 = ₹80 lakh
Loss after recovery = ₹80 lakh × 0.70 = ₹56 lakh
The bank faces a credit risk of ₹56 lakh.
How Credit Risk Influences Interest Rate
The credit risk has a direct impact on the interest rate. If the default chances are higher, the lenders charge extra to compensate for the uncertainty.
For example, two persons A and B, approach a lender for loans. The lender assesses their repayment records and income to determine the interest rates.
A, who turns out to be at low-risk of default, is charged 8%, while B is charged 14% because he is at a higher risk of default. The extra 6% is known as the risk premium.
In simple words, higher credit risk leads to higher borrowing costs in order to balance potential losses.
How to Manage Credit Risk
You cannot eliminate credit risk, but it can be controlled with proper management practices.
- Credit Assessment
The first step to managing the credit risk is the evaluation of the borrower. Evaluate their source of income, repayment history, and outstanding debts. For businesses, you can apply debt-to-equity and interest coverage ratios for the assessment.
A proper background check helps in avoiding lending to high-risk borrowers.
- Diversify Exposure
If too much money is lent to a specific borrower or industry, it increases the magnitude of risk. Diversification helps in spreading the risk and limits potential loss from the failure of any one particular party or sector.
As seen in the concentration risk example discussed earlier, instead of allocating a huge amount to real estate, the bank could have spread it over manufacturing or retail segments.
- Collateral and Guarantees
When the loan is backed by assets, the recovery becomes easier in the case of default. Using collateral aids in lowering the potential loss.
You can use third-party guarantees for additional safety of your lent amount.
- Provisions and Risk Buffers
Some funds should be set aside to absorb the losses. They act as safety cushions during economic distress and help in maintaining stability.
Central banks usually set minimum capital reserve limits that all other banks have to follow based on their credit exposure.
What are the 5Cs of credit?
The 5C framework is widely used in evaluating borrowers.
- Character: It refers to the borrower’s reputation and credit history. The character helps in judging their trustworthiness.
- Capacity: The capacity means the borrower’s ability to repay the loans. Ratios like the Debt Service Coverage and Debt to Equity are used to measure it.
- Capital: The borrower’s overall net worth is known as the capital. It is used to measure their financial strength. The capital is the amount left over by subtracting liabilities from assets.
- Collateral: The securities pledged against the loan are known as collateral. High quality and liquid assets allow easy access in case the borrower defaults.
- Conditions: The specific terms of the loan, like fees, repayment timings, and interest rates, are determined to match the suitability of the borrower.
Credit Risk vs Interest Rate
Credit risk and interest rate are related but not identical. The following table presents their differences:
| Basis | Credit Risk | Interest Rate |
| Meaning | It is the possibility of a borrower’s failure in meeting his obligations | Interest rate is the cost charged for borrowing money |
| Nature | Measures uncertainty of repayment | Measures price of borrowing |
| Impact | Higher risk increases chances of loss | Higher rate increases borrowing cost |
| Influenced By | Financial health, repayment history, economic stability | Credit risk, inflation, central bank policies |
Conclusion
Credit risk is an unavoidable part of any lending activity. Whenever you lend money, there is always a chance that the borrower may not pay you back.
By understanding the types of credit risk and using risk management practices, we can improve our financial stability. Sound judgment and evaluation are the foundation of sustainable lending and investing decisions.
FAQs
The three main types of credit risk are default risk, concentration risk, and country risk. These represent borrower non-payment, excessive exposure to one sector or borrower, and risks arising from economic or political instability.
An example of credit risk is when an investor purchases bonds worth ₹2,00,000 and the issuer fails to repay only half of the principal at maturity, causing a loss of ₹1,00,000 to the investor.
Credit risk is often referred to as default risk, especially when it specifically relates to a borrower’s failure to repay interest or principal.
The five important terms of credit are Character, Capacity, Capital, Collateral, and Conditions. Together, they form the 5C framework used by lenders to evaluate a borrower’s creditworthiness.
