Credit risk analysis is the process of estimating or predicting the costs associated when a loan is approved. This is an extension of the method of the process of credit allocation.
After an organisation or even an individual applies to any financial institution, like a bank for a loan, the bank analyses the associated costs and benefits of the loan. Credit risk analysis helps understand whether a borrower may be unable to repay his loan and the financier or the lender may be at risk of loss if the loan obligations as per the contract are not met.
The lender’s cash flow is affected when the interest or the principal amounts are not paid off on time. Additionally, this leads to an increase in the cost of collection. While there is always a certain amount of forecasting involved in which borrowers might default on repayment, the process of intelligent and organised risk analysis may help understand the predicted amount of loss and its severity.
Who Requires Credit Risk Analysis?
Credit risk analysis holds the utmost importance for various financial institutions and banks, who offer loans, credit cards, mortgages and more. Other credit offering companies, bond issuers, investors, insurance companies are required to be aware of credit risk analysis techniques.
Risk analysis is important for managing risks effectively, mitigation and timely recovery of the loans.
Conditions for effective risk analysis
Credit risks are always analysed on the ability of a borrower to stick to the contract while repaying the loan. Effective credit risk analysis involves 5Cs.
● Capital of business- how much the borrower has contributed from his end. The loan terms are always better when his cash flow is higher since the equity capital lowers the lender’s leverage. The more the merrier!
● Credit history- How trustworthy the past instances of credit handling have been from the borrower’s end; if there have been bankruptcies, court cases or foreclosures and more. All of these factors are analysed by lenders before they wave green on your loan.
● Capacity of repayment- What the borrower’s cash flow is, how is he going to make the repayment and what are the terms associated with repayment.
● Conditions of the loan- These can vary, depending on the industry it is relevant to, the size of the loan, what it’s intended use is, present economic policies, prevalent market rates and more.
● Collateral associated to the loan- This factor makes up and covers for any non-repayment risks that are associated with a loan.
Risk analysis can be done after the market values are studied and acceptability of asset is understood. It can be done in several methods by making use of personal appraisals, trained risk accessors, or even credit risk assessment of other customers who’ve loaned money.
The credit rating of bonds is another factor that investors take note of. While bonds that have ratings as B or as low as C are most probably going to default on payments while offering higher returns, bonds with A, AA or AAA rating are considered to be in the category of a safe investment.
Credit risk analysis and its impact on interest rates
Most investments look for a higher rate of interest, since the higher the credit risk analysed or predicted, the higher is the rate of interest for the borrowed capital. Often if risks are perceived as too high, lenders, financiers or banks may decline the investment or loan offer altogether. Lenders always prefer their borrowers to have a good credit rating and the offer the capital at lower rates of interest.
Bonds that have lower ratings offer returns that are more attractive and viable to investors who prefer to take up risks. Borrowers with better credit ratings avail loans at lower rates of interest.
Credit analysis helps gain an overview of the fact that if a borrower, the business or the bond-issuer is creditworthy or not. It also evaluates the borrower or the borrowing company in general and also their ability to repay a loan. Financial audited statements from other companies are often used to rate the creditworthiness of an organization and the bond issues that may be involved.
Common credit analysis courses may help a professional to more about its financial workings.