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Credit Risk Analysis

The process of estimating the potential benefits and costs associated with the loan

What is Credit Risk Analysis?

Credit risk analysis can be thought of as an extension of the credit allocation process. After an individual or business applies to a bank or financial institution for a loan, the lending institution analyzes the potential benefits and costs associated with the loan. Credit risk analysis is used to estimate the costs associated with the loan. To learn more, check out CFI’s Credit Analyst Certification program.

 

Credit Risk Analysis

 

Credit risk or credit default risk is a type of risk faced by lenders. Credit risk arises because a debtor can always renege on their debt payments. Commercial banks, investment banks, asset management companies, private equity funds, venture capital funds, and insurance companies all need to analyze the credit risks they are exposed to in order to profitably operate in the market.

 

Summary:

  • Credit risk analysis can be thought of as an extension of the credit allocation process. After an individual or business applies to a bank or financial institution for a loan, the bank or financial institution analyzes the potential benefits and costs associated with the loan.
  • Credit risk or credit default risk is a type of risk faced by lenders. Credit risk arises because a debtor can always renege on their debt payments.
  • In the lead-up to the 2008 Great Recession, commercial banks, investment banks, and other financial markets participants underestimated both the default probability and the loss rate and consequently underestimated the credit risk they were facing.

 

What is Credit Risk?

Credit risk or credit default risk associated with a financial transaction is simply the expected loss of that transaction. It can be defined as follows:

 

Credit Risk  =  Default Probability  x  Exposure  x  Loss Rate

 

Where:

  • Default Probability is the probability of a debtor reneging on his debt payments.
  • Exposure is the total amount the lender is supposed to get paid. In most cases, it is simply the amount borrowed by the debtor plus interest payments.
  • Loss Rate = 1 – Recovery Rate, where Recovery Rate is the proportion of the total amount that can be recovered if the debtor defaults. Credit risk analysts analyze each of the determinants of credit risk and try to minimize the aggregate risk faced by an organization.

 

Types of Credit Risk

 

1. Concentration risk

Concentration risk, also known as industry risk, is the risk arising from gaining too much exposure to any one industry or sector. For example, an investor who lent money to battery manufacturers, tire manufacturers, and oil companies is extremely vulnerable to shocks affecting the automobile sector.

 

2. Institutional risk

Institutional risk is the risk associated with the breakdown of the legal structure or of the entity that supervises the contract between the lender and the debtor. For example, a lender who gave money to a property developer operating in a politically unstable country needs to account for the fact that a change in the political regime could drastically increase the default probability and the loss rate.

 

Credit Risk, the Housing Bubble, and the Great Recession

Improper risk management by banks and other financial institutions was a key factor behind the US housing bubble in the mid-2000s that eventually led to the 2008 recession. Commercial banks, investment banks, and other financial markets participants underestimated both the default probability and the loss rate and consequently underestimated the credit risk they were facing.

In the lead-up to the recession, most lenders gave loans to individuals and businesses with questionable credit history. The fact was most evident in the housing market, where easy credit led to house prices rising rapidly in the mid-2000s. Increased house prices meant borrowers could refinance their mortgages and borrow even more money, which fueled the bubble even further.

 

Additional Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)™ program for finance professionals looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant CFI resources below:

  • Commercial Credit Analyst
  • Debt Covenants
  • Financial Intermediary
  • Probability of Default