It might be impossible to know if a lender will not be able to meet contractual obligations due on loan even after a rigorous and lengthy assessment. However, managing credit risk can reduce the severity of a potential loss. The reward for the lenders taking on these risks is gained from the interest charged on the loan
What Is Credit Risk
Credit risk is a possible loss resulting from a borrower’s inability to make payments of a loan or meet his/her contractual obligations. Simply put, it is a risk that a lender faces on the possibility of not receiving the owed principal and interest. The risk results in an interruption of cash flows and higher costs of collection.
Types Of Credit Risk
There are typically three types of credit risk, and they are:
- Default credit risk arising when the borrower is not able to pay the principal loan amount due
- The risk resulting from the reduction in the risk rating of an issuer
- Credit spread risk occurring due to inconsistency in the variance between interest rates in investments and the risk-free return rate.
Credit Risk Management
After the economic meltdown in 2008, many companies realized that there is no such thing as a “big company” if you do not make enough provision for risk assessment. Even if your business is safe, you might be connected to some risky businesses in which their downfall could ultimately lead to yours.
As a result, businesses have to adhere to strict legislation as well as heightened requirements for accountability and risk management. In the last decade, credit risk has grown to become a strategic sustainability measure.
The Benefits of Credit Risk Management
The significant advantage of credit risk management is to mitigate risks arising from credit transactions which will ultimately reduce risk. They can also include the following.
- It allows you to identify potential clients that may come at too high a risk and above your risk tolerance
- Credit risk can be leveraged as a strategic opportunity
- It is also able to improve the overall performance of the business substantially as well as give the business a competitive advantage
How To Mitigate Credit Risk
There are several ways you can use to reduce your credit risk to the barest minimum. Some of them are mentioned below and they are:
- Check the credit records of a potential customer thoroughly. Starting with credit scores which can give you an indication of the kind of risk your potential customer is carrying.
- Build a long term customer relationship with the client
- Your agreement with your customer must be in clear terms. Be sure to draft your lending terms and condition
- Establish a credit limit for a potential customer
- Having a standard policy as to dealing with overdue payments can also go a long way.
- You can opt for the credit insurance to your advantage. Here, the insurance company becomes liable to pay the debt if the borrower defaults.
Credit risk is also closely related to an investment’s return, the most common example being that the yields on bonds strongly correlates to their intended credit risk. The higher the credit risk, the higher the interest rates demanded by investors for lending their capital. As lenders get very discouraged with customers having low credit scores.