Credit risk is when a lender lends money to a borrower but may not be paid back.
Loans are extended to borrowers based on the business or the individual’s ability to service future payment obligations (of principal and interest).
Lenders go to great lengths to understand a borrower’s financial health and to quantify the risk that the borrower may trigger an event of default in the future.
Credit risk is a specific financial risk borne by lenders when they extend credit to a borrower.
Lenders seek to manage credit risk by designing measurement tools to quantify the risk of default, then by employing mitigation strategies to minimize loan loss in the event a default does occur.
The 5 Cs of Credit is a helpful framework to better understand credit risk and credit analysis.
Managing Credit Risk
Credit risk management is a multi-step process, but it can broadly be split into two main categories. They are:
Measuring Credit Risk
Credit risk is measured by lenders using proprietary risk rating tools, which differ by firm or jurisdiction and are based on whether the debtor is a personal or a business borrower.
In personal lending, creditors will want to know the borrower’s financial situation – do they have other assets, other liabilities, what is their income (relative to all of their obligations), and how does their credit history look? Personal lending tends to rely on a personal guarantee and collateral.
On the other hand, commercial lending is much more complex; many business clients borrow larger dollar amounts than individuals. Risk rating a commercial borrower requires a variety of qualitative and quantitative techniques. Categories of qualitative risk assessment include:
Understanding what’s going on in the business environment and the broader economy
Analyzing the industry in which the borrower operates
Evaluating the business itself – including its competitive advantage(s) and management’s growth strategies
Analyzing and understanding the management team and ownership (if the business is privately owned). Management’s reputation and owner’s personal credit scores will be included in the analysis.
The quantitative part of the credit risk assessment is financial analysis. Lenders evaluate a variety of performance and financial ratios to understand the borrower’s overall financial health.
Based on the lender’s proprietary analysis techniques, models, and underwriting parameters more broadly, a borrower’s credit assessment will yield a score.
The score may be called several different things. For example, the scores for public debt instruments are referred to as credit ratings or debt ratings (i.e., AAA, BB+, etc.); for personal borrowers, they may be called risk ratings (or something similar).
The score itself ranks the likelihood that the borrower will trigger an event of default. The better the score/credit rating, the less likely the borrower is to default; the lower the score/rating, the more likely the borrower is to default.
Mitigating Credit Risk
Credit risk, if not mitigated appropriately, can result in loan losses for a lender; the losses adversely affect the profitability of financial services firms. Some examples of strategies that lenders use to mitigate credit risk (and loan loss) include, but are not limited to:
Credit risk can be partially mitigated through credit structuring techniques.
Elements of credit structure include the amortization period, the use of (and the quality of) collateral security, LTVs (loan-to-value), and loan covenants, among others.
For example, if a borrower is riskier, they may have to accept a shorter amortization period than the norm. Perhaps a borrower will be required to provide more frequent (or more robust) financial reporting.
Understanding any collateral security that is available and structuring credit accordingly are paramount.
Sensitivity analysis is when a lender changes certain variables in the proposed credit structure to see what the borrower’s credit risk would look like if the hypothetical conditions became a reality. Examples include:
Suppose a lender intends to extend credit at a 5% interest rate; they may wish to see what the borrower’s credit metrics look like at 7% or 8% (in the event that rates ever increase materially). It is sometimes called a “qualifying rate.”
Perhaps a lender plans to offer a borrower a 10-year term loan; they may wish to see what the credit metrics look like if that loan were instead a 6- or 7-year amortization (in the event that conditions changed and the lender wanted to accelerate the repayment of the loan).
Financial institutions and non-bank lenders may also employ portfolio-level controls to mitigate credit risk.
Strategies include monitoring and understanding what proportion of the total loan book is a particular type of credit or what proportion of total borrowers are a certain risk score.
Example 1: The risk management team at a bank unanimously agrees that the housing market will face headwinds over the next 12-18 months. To be proactive, they may restrict residential mortgages with high-risk profiles (as a proportion of total firm-wide exposure) to not greater than X% of all credit outstanding.
Example 2: Based on the economic cycle, the risk management team anticipates that a recession may be looming. It may seek to restrict extending loans to certain borrowers with a risk score of less than X.
The 5 Cs of Credit
A framework that is commonly employed to help understand, measure, and mitigate credit risk is the 5 Cs of Credit. The 5 Cs are:
If it’s a personal borrower, what kind of person are they, and do they have a strong credit history?
With commercial borrowers, character describes company management’s reputation and credibility; character also extends to company ownership if it’s a private corporation.
Capacity speaks to a borrower’s ability to take on and service debt obligations. For both retail and commercial borrowers, various debt service and coverage ratios are used to measure a borrower’s capacity.
For commercial lenders, this is where understanding the borrower’s competitive advantage comes in – since its ability to maintain or grow this advantage will influence the borrower’s ability to generate cash flow in the future.
Capital is often characterized as a borrower’s “wealth” or overall financial strength. Lenders will seek to understand the proportion of debt and equity that support the borrower’s asset base.
Understanding if a borrower may be able to source alternative funds from elsewhere is also important. Is there a related company that has liquidity (for a business borrower)? Is there a parent or family member that could provide a guarantee for a personal borrower (who maybe doesn’t have a long credit history)?
Collateral security is a very important part of structuring loans to mitigate credit risk.
It is critical to understand what assets are worth, where they’re located, how easily the title can be transferred, and what appropriate LTVs are (among other things).
Conditions refer to the purpose of the credit, extrinsic circumstances, and other forces in the external environment that may create risks or opportunities for a borrower.
They can include political or macroeconomic factors, or the stage in the economic cycle. For business borrowers, conditions include industry-specific challenges and social or technological developments that may affect competitive advantage.
Thank you for reading CFI’s guide to Credit Risk. To keep advancing your career, the additional CFI resources below will be useful: