What is Credit Risk?
Risk is a part and parcel of conducting business, the degree and types of risk vary depending upon the nature of business. Credit risk can be explained as the risk of loss arising due to the failure of a borrower to meet its loan obligations. In simpler terms, when a borrower is not able to repay the loan amount as per the terms and conditions of the agreement, a credit risk situation arises. Credit risk is far too common in the banking and finance industry and an increase in credit risk leads to loss for banking and financial institutions. It also severely impacts the cash-flow of the business.
Credit Risk Analysis
Now to tackle the situation of huge losses arising on account of credit risk, banks and financial institutions who are primarily involved in lending money takes all necessary measure to mitigate and reduce the risk. Credit risk analysis can be understood as a measure to mitigate credit risk. The credit risk analysis process involves assessing the probability of loss due to default by the borrower. It also evaluates the actual amount and extent of loss that will arise when the borrower fails to meet his/her repayment obligations as per the terms of the loan agreement.
Credit risk analysis is primarily carried out by banks, financial institutions and NBFCs as they are primarily involved in the process of loaning out funds for various needs. In addition to this, insurance companies and bond issuers also need effective credit risk analysis to minimize loses and boost profitability. Effective credit risk analysis helps to ease the lending process and this is much needed in the current digital economy where customers don’t like to wait long for goods and services. Credit risk analysis is an indispensable process for all major financial and banking institutions that deal in a large volume of loans and monetary transactions.
Why Conduct Credit Risk Analysis?
Now that we have a complete understanding of what credit risk analysis is let’s delve deeper into why is it important to conduct credit risk analysis and how it helps.
- Helps to calculate the probability of default: The probability of default is an important factor needed to calculate the exact amount of loss due to default by borrower or credit risk. The probability of default is generally explained as the likelihood of the borrower failing to meet the principal and interest repayment within a given time frame, generally one year period. The two important determinants of the default probability are the borrower’s personal characteristic and the overall economic scenario.
- To calculate exposure and loss at default: A comprehensive credit risk analysis helps to determine the exposure and actual amount of loss in case of default by the borrower. Banks and financial institutions often need to determine the exposure in case of loss to be prepared in advance. In addition to this, the actual amount of loss at the time of default helps to provide better estimates of the liabilities associated with banks and financial institutions. It helps banks to keep the credit risk exposure in an acceptable range that is within its risk-taking capability.
- Mitigating and controlling credit risk: The most important reason why banks and other financial institutions conduct credit risk analysis is to mitigate or control their credit risk exposure. Effective credit risk analysis helps to provide important information regarding the borrower’s financial standing and helps to eliminate the high-risk borrowers. These institutions can establish an acceptable credit risk range and allow loans only to borrowers that meet the criteria and fall within the set risk limit.
The role of credit risk analysis has gain importance in the past decades, especially after the global financial crisis. Credit risk analyst is one of the most sought-after career options for people who want to get into finance and banking related sector. A credit risk course helps you boost your career prospects in this industry. One can opt for a credit risk course by reputed institutions like Imarticus Learning that also guarantees placement and imparts you with relevant knowledge and skills need to do the job.
Also Read: What is Credit Risk Analysis and Why It is Important