Define and Describe Credit Risk
Subject: Finance | Topics:

CREDIT RISK:

George E. Peterson (1998) defines credit risk, as “Credit risk is the risk that a borrower will not make full and timely payment of debt service. Once a borrower falls behind in debt servicing, credit risk also involves the relative size and probable duration of default.” It is one of the significant risks a bank is exposed to. Each of the risk areas requires to be evaluated and aggregated to arrive at an overall risk grading measure.

a)      Evaluation of financial risk: Financial analysis of leverage, liquidity, profitability and interest coverage ratios will help to analyze the risk that borrower might fail to meet obligation due to financial distress.

b)      Evaluation of Business/Industry Risk: Analyzing the business outlook, size of business, industry growth, market completion and barriers to entry or exit to understand the industry situation or unfavorable business condition that might have an impact on borrower’s capacity to meet obligation. This capitalizes on the risk of failure due to low market share and poor industry growth.

c)      Evaluation of Management Risk: Due to poor management skill, experience of the management, its succession plan and teamwork might cause the borrower to default.

d)     Evaluation of Security Risk: Risk that the bank might be exposed due to poor quality or strength of the security in case of default. This may involve the strength of security and collateral, location of collateral and support.

e)      Evaluation of Relationship Risk: These risk areas cover evaluation of limits utilization, account performance, conditions / covenants compliance by the borrower and deposit relationship.

 

CREDIT RISK ANALYSIS:

The term credit analysis is used to describe any process for assessing the credit quality of a company or individual. Credit analysis include credit scoring, it is more commonly used to refer to process that entail human judgment. Credit professionals in banks review the client’s balance sheet, income statement, recent trends in its industry, the current economic environment, etc. from this they can also assess the exact nature of an obligation. Based on this analysis, the credit manager assigns the client a credit rating, which can be used for making credit decision.

Many banks, investment managers and insurance companies hire their own credit analysts who prepare credit ratings for internal use. In Bangladesh there are two rating agencies one is CRAB (Credit Rating Agency of Bangladesh) and another is CRISAL. These two does the rating of all organizations.

Related Finance Paper: