Credit risk refers to the risk of failure of repayment of the principal and interest of the loan from the loan borrower to the lender. Whenever a borrower defaults on his/her payments of the loan there occurs an interruption in the cash flow to the lender. To compensate for the risk of the loss of payment, the lender uses the interest payment from the loan.
Credit risk analysis helps the lenders evaluate the financial capability of the borrower to repay the loan so that the lender remains protected from the losses. Any borrower with high credit risk is charged a high rate of interest as compensation for the high risk of the payment default. There are 5C’s of credit that a lender must keep in mind while assessing the credit risk of the borrower. These factors include:
● Capacity (to repay the credit)
A borrower is judged on these above-mentioned aspects to evaluate the probability of any payment default or subsequent financial loss. These 5C’s measure both quantitative and qualitative values. A lender may analyze various documents that include the borrower’s income proof, purchase history, credit reports, balance sheets, etc. for this purpose.
The primary objective of the analysis of credit risk is to reduce the default returns and maximize the returns. Loans are the chief money-making source of banks. However, when it lends credit to a person or a business, there is always a risk associated with it for non-repayment or default in repayment. This can result in a bank suffering financial losses.
To mitigate this risk, the bank analyzes the probability of defaults and gives a score like a credit score rating. It can also use credit ratings calculated by other financial institutions like CRISIL, moody’s, etc. The higher the rating, the better it is for the borrower as it indicates a better capability of repayment and thus will result in lower interest rates. However, if the rating is low, it indicates greater chances of defaults leading to higher interest rates.
To safeguard themselves from the damage, every bank has a minimum required rating for the borrower to become eligible for a loan. In addition to this, banks also demand collateral from the borrower like property in case of a house loan, car in case of a car loan, etc. If the borrower fails to repay the loan, the bank has the right to sell the collateral and recover their money.
Credit Analysts use different kinds of financial techniques to measure credit risk. These techniques include ratio analysis, trend analysis, etc. These techniques help the banks measure the changing creditworthiness of the borrower and thus evaluate the potential of credit loss. Credit Analysts play an important role in banks by helping them analyze their loan borrowers and reduce the risk of defaults. They help save the money of the bank and in fact, increase it skillfully through identifying good loan borrowers. A credit analyst career has a bright scope with a good pay scale. Anyone with a financial, accounting, or related degree or a credit risk course can become a credit analyst. There are various pathways in this role that one can take on with experience or further qualification advancements through a master’s degree or a certified credit risk course from a reputed institution. A good credit risk professional should follow all the principles of credit risk management to be better perform the job and help banks make better decisions regarding the loan process.