Investment banking is focused on generating capital. An investment bank helps its clients from facilitating mergers and acquisitions to providing guidance on all the issues. But besides all the prevailing issues and risks, there is a risk called credit risk. A good investment banker should know ways to manage and identify credit risk. We will know more about credit risk in this article in detail.
Understanding Credit Risk In Investment Banking
Credit risk is defined as the loss and vulnerability generated by the borrower failing in repaying the taken loans due to respective conditions. This results in a lot of imbalance in cash flow. So, a good investment tries to find out the possibility of credit risk in its clients and be prepared on how to cope up when such situations arrive. These types of clients are not good for business and lack accountability.
Such clients often end up giving higher interest rates on their base amount due to late payments and unaccountability. It is hard to know who will turn up as defaulter in advance, but then again, a good investment bank must know ways to manage the information of its clients and discover the credit risk.
How Bankers Calculate Credit Risk?
Customers failing to return loans, mortgages, credit card payments create a loss for the lender. The financial institutions have people assigned specially to determine credit risk. To determine credit risk, you have to look at the five Cs which are credit history of the client, capital, capacity to repay, conditions of the loan and collateral associated with the loan transfer and processing.
If we talk in terms of bonds, then the investor analyses these 5 Cs of the issuer and if the credit rating is high, then it can be considered as a safe investment. If you borrow loans, then make sure your credit rating is high, so you don’t turn up in the list of defaulters. Technology has also offered a lending hand to detect credit risk. Smart data analysis techniques help in finding meaningful information.
The Formula Of Credit Risk
There are many types of credit risks like concentration risk, country risk, etc. But in terms of investment banking sometimes the investor wants to know the credit risk values mathematically. The formula which is calculated based on 5 aforementioned Cs and some more attributes are:
Expected loss or credit risk = probability of default (PD)* exposure at default (EAD)* (1 – loss given default (LGD)).
EAD is defined as the credit extended to the client.
PD is defined as the low rating and hindrances generating the probability of credit risk. If the loss is to be calculated assuming the company is in default then PD would be 100%.
LGD is also calculated by the loss encountered by the company.
Some Good Practices To Lower Your Chance Of Credit Risk
• Know your customer thoroughly including his past credit records and current credit ratings.
• Keep track of those risks too which are not financially related but can generate situations of loss such as health and capital of a client.
• The deal with a client should be conducted in a structured manner with full paperwork and professionalism.
• Monitor your relationship with the client and try not to lose contact during the entire credit cycle.
• Be updated with modern information analytics tools and techniques. This will help the financial institution to save their time, money and service.
Credit risk can come in all types of debts generated due to loan defaulters. A company can also fail to return the initial investment provided by any financial institution. To avoid these types of risks a bank should identify such clients in advance and as we know ‘Prevention is better than cure’. This article was all about understanding credit risk in investment banking and some ways to cope up with it. I hope it helps!
Also Read: What is Credit Risk For Banks