Credit risk

In its most basic form, credit risk is a financial term indicating the possibility that someone who borrows money will not be able to repay it as originally agreed. People who lend money, or provide services that may be paid for later, undertake some degree of credit risk in every transaction. No financial company can predict with complete accuracy which borrowers are or are not reliable. To deal with the inevitability of credit risk, lending companies attempt to mitigate the risk through investigation of the potential borrower. This may include researching the borrower’s past financial history and credit score. People with poor reputations as borrowers may be denied new loans or forced to pay higher interest or fees. Credit companies profit through the interest and fees, which is basically their reward for assuming credit risk.

Background

Credit refers to consumers’ ability to borrow money with the understanding that they will repay it by a mutually agreed-upon future time. A creditor is a person or group that provides credit to others. Creditors may include lenders such as banks, merchants in a variety of industries, or various types of service providers that may provide a service now that the consumer must pay for later.

Creditors generally charge fees when people borrow their money, as well as a variety of penalties for late repayments. Still, being a creditor can be a risky position because many people and groups that use credit are late to repay their debt or fail to do so. For that reason, creditors generally only extend credit to consumers who are trustworthy, or creditworthy.

Creditworthy borrowers generally have high credit scores, or ratings in their reliability in repaying borrowed funds on time. Credit scores take into account many factors, including how many credit cards the person has (along with the cards’ limits and balances), any loans the person may have taken and whether they were repaid on time, and major financial setbacks the person may have experienced (such as bankruptcy, repossessions, or foreclosures).

For many people, credit is an important part of life. Having good credit allows a person to make purchases without carrying cash. It also helps people to make large purchases, such as homes or cars, without having all the necessary funds available at the time of purchase. These consumers must maintain a good credit history to ensure that they will be able to continue borrowing. Borrowers who consistently fail to repay on time are likely to be viewed by potential creditors as a credit risk.

Overview

Credit risk refers to the possibility that a borrower will not repay borrowed money or meet the agreed-upon obligations of a contract. Credit risk especially focuses on instances when a creditor faced a loss due to the borrower’s negligence. When a borrower does not repay or fulfill obligations on the agreed-upon schedule, the creditor may lose some or all the borrowed money or the unpaid-for services. This can seriously disrupt the creditor’s cash flow. In addition, it may require the creditor to take on the additional expenses of investigating the delinquent borrower or seeking to collect or repossess what was due.

Creditors must face the possibility of credit risks as part of regular business, however. Credit companies have no way to estimate a potential borrower’s reliability with complete accuracy. Sometimes, people with poor credit change their behavior or circumstances and go on to demonstrate perfect payment. Other times, people with otherwise exemplary financial reputations may default on loans for any number of reasons.

However, credit companies can help mitigate this risk with careful assessment and risk management techniques. The main way is to treat potential borrowers differently based on their perceived risk level. People with a high potential risk may be denied loans altogether. Creditors may charge higher interest rates to people with heightened potential for credit risk. This practice helps the creditor build up larger stores of money, some of which may be earmarked for collecting unpaid debts or simply making up for irretrievable money or services. Financial experts view the interest rates charged by creditors as a sort of reward for the creditors’ assumption of risk in every transaction.

Creditors use a variety of methods to estimate a person’s likely credit risk. One of the traditional methods is to build an equation based on the so-called five Cs. The first of these is credit history, or recorded information about the person’s past financial activity. The second is capacity to repay, or the borrower’s existing wealth or income at the time of the loan. The third is capital, which relates to the size of the loan being considered. The fourth is the conditions of the loan, such as the payment schedule and deadline and any associated interest or fees. Finally, the fifth element is collateral, which refers to all other sources of value, such as real estate and personal property, that the borrower may own.

Some creditors use other variations of the C system. They may include factors such as communication, or the reliability and willingness of a potential borrower to honestly discuss the situation. They may also consider the potential borrower’s character—basically, the personality and status of the person, such as his or her reputation in society, work experience, and type of job.

Many parties may take an interest in a person’s credit and seek to avoid conducting business with those who present a perceived credit risk. Clearly, lenders such as banks are most likely to scrutinize credit histories and avoid risky borrowers. Utility companies may check a potential client’s credit ratings before agreeing to let that person open an account. Insurance companies may take credit score into account when calculating certain insurance rates. Employers and landlords may also request credit information when they are deciding whether to hire or rent to individuals they do not already know. In those cases, people who are potential credit risks may be deemed unreliable tenants or employees lacking in financial abilities.

Bibliography

Basel Committee on Banking Supervision. “Principles for the Management of Credit Risk.” Basel, Sept. 2000, www.bis.org/publ/bcbs75.pdf. Accessed 3 Jan. 2025.

Bouteillé, Sylvain, and Diane Coogan-Pushner. The Handbook of Credit Risk Management. Wiley, 2012.

Bucci, Steve. “What Is a Credit Risk?” Bankrate.com, 23 Oct. 2023, www.bankrate.com/glossary/c/credit-risk/. Accessed 3 Jan. 2025.

“Credit Risk: Definition, Role of Ratings, and Examples.” Investopedia, 23 Sept. 2024, www.investopedia.com/terms/c/creditrisk.asp. Accessed 3 Jan. 2025.

“Credit Risk Management.” Board of Governors of the Federal Reserve System, 31 Dec. 2024, www.federalreserve.gov/supervisionreg/topics/credit‗risk.htm. Accessed 3 Jan. 2025.

“Credit Risk Management.” SAS Institute, 2022, www.sas.com/en‗us/insights/risk-management/credit-risk-management.html. Accessed 3 Jan. 2025.

Godley, Wynne, and Marc Lavoie. Monetary Economics: An Integrated Approach to Credit, Money, Income, Production, and Wealth. Palgrave Macmillan, 2007.

Peterdy, Kyle. “What Is Credit Risk?” Corporate Finance Institute, 2022, corporatefinanceinstitute.com/resources/knowledge/finance/credit-risk/. Accessed 3 Jan. 2025

Ross, Sean. “How to Quantify Credit Risk.” Investopedia, 20 Mar. 2023, www.investopedia.com/ask/answers/022415/what-factors-are-taken-account-quantify-credit-risk.asp. Accessed 3 Jan. 2025.