Financial institutions used credit risk analysis models to determine the probability of default of a potential borrower. The models provide information on the level of a borrower’s credit risk at any particular time. If the lender fails to detect the credit risk in advance, it exposes them to the risk of default and loss of funds. Lenders rely on the validation provided by credit risk analysis models to make key lending decisions on whether or not to extend credit to the borrower and the credit to be charged.
With the continuous evolution of technology, banks are continually researching and developing effective ways of modeling credit risk. A growing number of financial institutions are investing in new technologies and human resources to make it possible to create credit risk models using machine learning languages, such as Python and other analytics-friendly languages. It ensures that the models created produce data that are both accurate and scientific.
Credit risk modeling is a technique used by lenders to determine the level of credit risk associated with extending credit to a borrower.
Credit risk analysis models can be based on either financial statement analysis, default probability, or machine learning.
High levels of credit risk can impact the lender negatively by increasing collection costs and disrupting the consistency of cash flows.
What is Credit Risk?
Credit risk arises when a corporate or individual borrower fails to meet their debt obligations. It is the probability that the lender will not receive the principal and interest payments of a debt required to service the debt extended to a borrower.
On the side of the lender, credit risk will disrupt its cash flows and also increase collection costs, since the lender may be forced to hire a debt collection agency to enforce the collection. The loss may be partial or complete, where the lender incurs a loss of part of the loan or the entire loan extended to the borrower.
The interest rate charged on a loan serves as the lender’s reward for accepting to bear credit risk. In an efficient market system, banks charge a high interest rate for high-risk loans as a way of compensating for the high risk of default. For example, a corporate borrower with a steady income and a good credit history can get credit at a lower interest rate than what high-risk borrowers would be charged.
Conversely, when transacting with a corporate borrower with a poor credit history, the lender can decide to charge a high interest rate for the loan or reject the loan application altogether. Lenders can use different methods to assess the level of credit risk of a potential borrower in order to mitigate losses and avoid delayed payments.
Types of Credit Risk
The following are the main types of credit risks:
1. Credit default risk
Credit default risk occurs when the borrower is unable to pay the loan obligation in full or when the borrower is already 90 days past the due date of the loan repayment. The credit default risk may affect all credit-sensitive financial transactions such as loans, bonds, securities, and derivatives.
The level of default risk can change due to a broader economic change. It can also be due because of a change in a borrower’s economic situation, such as increased competition or recession, which can affect the company’s ability to set aside principal and interest payments on the loan.
2. Concentration risk
Concentration risk is the level of risk that arises from exposure to a single counterparty or sector, and it offers the potential to produce large amounts of losses that may threaten the lender’s core operations. The risk results from the observation that more concentrated portfolios lack diversification, and therefore, the returns on the underlying assets are more correlated.
For example, a corporate borrower who relies on one major buyer for its main products has a high level of concentration risk and has the potential to incur a large amount of losses if the main buyer stops buying their products.
3. Country risk
Country risk is the risk that occurs when a country freezes foreign currency payments obligations, resulting in a default on its obligations. The risk is associated with the country’s political instability and macroeconomic performance, which may adversely affect the value of its assets or operating profits. The changes in the business environment will affect all companies operating within a particular country.
Factors Affecting Credit Risk Modeling
In order to minimize the level of credit risk, lenders should forecast credit risk with greater accuracy. Listed below are some of the factors that lenders should consider when assessing the level of credit risk:
1. Probability of Default (POD)
The probability of default, sometimes abbreviated as POD, is the likelihood that a borrower will default on their loan obligations. For individual borrowers, POD is based on a combination of two factors, i.e., credit score and debt-to-income ratio.
The POD for corporate borrowers is obtained from credit rating agencies. If the lender determines that a potential borrower demonstrates a lower probability of default, the loan will come with a low interest rate and low or no down payment on the loan. The risk is partly managed by pledging collateral against the loan.
2. Loss Given Default (LGD)
Loss given default (LGD) refers to the amount of loss that a lender will suffer in case a borrower defaults on the loan. For example, assume that two borrowers, A and B, with the same debt-to-income ratio and an identical credit score. Borrower A takes a loan of $10,000 while B takes a loan of $200,000.
The two borrowers present with different credit profiles, and the lender stands to suffer a greater loss when Borrower B defaults since the latter owes a larger amount. Although there is no standard practice of calculating LGD, lenders consider an entire portfolio of loans to determine the total exposure to loss.
3. Exposure at Default (EAD)
Exposure at Default (EAD) evaluates the amount of loss exposure that a lender is exposed to at any particular time, and it is an indicator of the risk appetite of the lender. EAD is an important concept that references both individual and corporate borrowers. It is calculated by multiplying each loan obligation by a specific percentage that is adjusted based on the particulars of the loan.
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