The main purpose of credit risk analysis is to quantify the level of credit risk that the borrower presents to the lender. It involves assigning measurable numbers to the estimated probability of default of the borrower.
Credit risk analysis is a form of analysis performed by a credit analyst on potential borrowers to determine their ability to meet debt obligations. The main goal of credit analysis is to determine the creditworthiness of potential borrowers and their ability to honor their debt obligations.
If the borrower presents an acceptable level of default risk, the analyst can recommend the approval of the credit application at the agreed terms. The outcome of the credit risk analysis determines the risk rating that the borrower will be assigned and their ability to access credit.
Credit risk analysis is a form of analysis performed by a credit analyst to determine a borrower’s ability to meet their debt obligations.
The purpose of credit analysis is to determine the creditworthiness of borrowers by quantifying the risk of loss that the lender is exposed to.
The three factors that lenders use to quantify credit risk include the probability of default, loss given default, and exposure at default.
Understanding Credit Risk
Credit risk is defined as the risk of loss resulting from the failure by a borrower to repay the principal and interest owed to the leader. The lender uses the interest payments from the loan to compensate for the risk of potential losses. When the borrower defaults on his/her obligations, it causes an interruption in the cash flows of the lender.
Performing credit risk analysis helps the lender determine the borrower’s ability to meet debt obligations in order to cushion itself from loss of cash flows and reduce the severity of losses. Borrowers who present a high level of credit risk are charged a high interest rate on the loan to compensate the lender for the high risk of default.
When calculating the credit risk of a particular borrower, lenders consider various factors commonly referred to as the “5 Cs of Credit.” The factors include the borrower’s capacity to repay credit, character, capital, conditions, and collateral. The lender uses the factors to evaluate the characteristics of the borrower and conditions of the loan to estimate the probability of default and the subsequent risk of financial loss.
The 5 Cs of Credit incorporate both qualitative and quantitative financial measures, and the lender may analyze different documents, such as the borrower’s income statement, balance sheet, credit reports, and other documents that reveal the financial situation of the borrower.
The Overarching Purpose of Credit Risk Analysis
Credit analysts may use various financial analysis techniques, such as ratio analysis and trend analysis to obtain measurable numbers that quantify the credit loss. The techniques measure the risk of credit loss due to changes in the creditworthiness of borrowers.
When measuring the credit loss, we consider both losses from counterparty default, as well as deteriorating credit risk rating.
Drivers that Quantify Credit Risk
The following are the key parameters that show a higher correlative relationship with credit risk:
1. Probability of default
Probability of default is defined as the probability that the borrower will not be able to make scheduled principal and interest payments over a specified period, usually one year. The default probability depends on both the borrower’s characteristics and the economic environment.
For individuals, the default probability is determined by the FICO score, and lenders use the score to decide whether or not to extend credit. For business entities, the default probability is implied by the credit rating.
Usually, credit rating agencies are required to assign a credit rating to entities that issue debt instruments, such as bonds. Borrowers with a high default probability are charged a higher interest rate to compensate the lender for bearing the higher default risk.
2. Loss given default
Loss given default is defined as the amount of money that a lender stands to lose when a borrower defaults on the debt obligations. While there is no accepted method for quantifying the loss given default per loan, most lenders calculate loss given default as a percentage of total exposure to loss in the entire loan portfolio.
For example, if ABC Bank lends $1,000 to Borrower A and $10,000 to Borrower B, the bank stands to lose more money in the event that Borrower B defaults on repayments.
3. Exposure at default
Exposure at default measures the amount of loss that a lender is exposed to at any particular point, due to loan defaults. Financial institutions often use their internal risk management models to estimate the level of exposure at default.
Initially, the exposure is calculated per loan, and banks use the figure to determine the overall default risk for the entire loan portfolio. As borrowers make loan repayments, the value of exposure at default reduces gradually.
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