What are the causes of credit risk?
The principal sources of credit risk within the Group arise from loans and advances, contingent liabilities, commitments, debt securities and derivatives to customers, financial institutions and sovereigns.
Credit risk is the probability of a financial loss resulting from a borrower's failure to repay a loan. Essentially, credit risk refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection.
Those include the financial health of the borrower, the severity of the consequences of a default (for both the borrower and the lender), the size of the credit extension, historical trends in default rates, and a variety of macroeconomic considerations, such as economic growth and interest rates.
To support the transformation process, the Accord has identified four drivers of credit risk: exposure, probability of default, loss given default, and maturity.
Lenders also use these five Cs—character, capacity, capital, collateral, and conditions—to set your loan rates and loan terms.
The key components of credit risk are risk of default and loss severity in the event of default. The product of the two is expected loss.
Credit risk can be partially mitigated through credit structuring techniques. Elements of credit structure include the amortization period, the use of (and the quality of) collateral security, LTVs (loan-to-value), and loan covenants, among others.
It binds the information collected into 4 broad categories namely Character; Capacity; Capital and Conditions. These Cs have been extended to 5 by adding 'Collateral', or extended to 6 by adding 'Competition' to it (Reference: Credit Management and Debt Recovery by Bobby Rozario, Puru Grover).
- Payment history.
- Current outstanding balances and debt.
- Amount of available credit being used, or credit utilization ratio.
- Length of time the accounts have been open.
- Derogatory marks, such as a debt sent to collection, a foreclosure or a bankruptcy.
- Total debt carried.
Credit Risk
It occurs when borrowers or counterparties fail to meet contractual obligations. An example is when borrowers default on a principal or interest payment of a loan. Defaults can occur on mortgages, credit cards, and fixed income securities.
Which type of credit carries the most risk?
Among the types of credit card, the one that carries the most risk are: Unsecured credit cards that have variable interest rate.
5 Cs of credit viz., character, capacity, capital, condition and commonsense. 7 Ps of farm credit - Principle of Productive purpose, Principle of personality, Principle of productivity, Principle of phased disbursem*nt, Principle of proper utilization, Principle of payment and Principle of protection.
Not paying your bills on time or using most of your available credit are things that can lower your credit score. Keeping your debt low and making all your minimum payments on time helps raise credit scores. Information can remain on your credit report for seven to 10 years.
Lenders generally see those with credit scores 670 and up as acceptable or lower-risk borrowers. Those with credit scores from 580 to 669 are generally seen as “subprime borrowers,” meaning they may find it more difficult to qualify for better loan terms.
Financial institutions face different types of credit risks—default risk, concentration risk, country risk, downgrade risk, and institutional risk. Lenders gauge creditworthiness using the “5 Cs” of credit risk—credit history, capacity to repay, capital, conditions of the loan, and collateral.
The Credit Risk Theory
In general, the higher the risk, the higher will be the interest rate that the debtors will be asked to pay on the debt. (Owojori, Akintoye & Adidu, (2011).
A credit risk model is used by a bank to estimate a credit portfolio's PDF. In this regard, credit risk models can be divided into two main classes: structural and reduced form models. Structural models are used to calculate the probability of default for a firm based on the value of its assets and liabilities.
In addition to your monthly income from wages earned, this can include social security income, rental property income, spousal support, or other non-taxable sources of income. Your work history: This helps lenders understand how stable your income is and how likely you are to repay your mortgage.
Credit reporting agencies (also known as credit bureaus or consumer reporting agencies) that collect information relevant to your credit and financial history. There are three credit agencies: TransUnion, Equifax, and Experian.
These can be summed up in the five C's of credit: Character, Capacity, Collateral, Capital and Conditions. In determining if a loan will be approved, banks typically look at: Three years of audited financial statements, plus the current year-to-date financial statement.
How do lenders know who the riskier borrowers are?
One of the first items a creditor or lender will examine to determine your creditworthiness (degree of risk) is your credit score. Since 90% of top lenders use FICO® Scores, which range from 300 - 850, they'll be looking for a score above 620 - especially for a conventional mortgage loan.
Aaa Obligations rated Aaa are judged to be of the highest quality, subject to the lowest level of credit risk.
The three main types of credit are revolving credit, installment, and open credit. Credit enables people to purchase goods or services using borrowed money. The lender expects to receive the payment back with extra money (called interest) after a certain amount of time.
Character, capital (or collateral), and capacity make up the three C's of credit. Credit history, sufficient finances for repayment, and collateral are all factors in establishing credit.
There are many ways to categorize a company's financial risks. One approach for this is provided by separating financial risk into four broad categories: market risk, credit risk, liquidity risk, and operational risk.
