Recent developments, such as the COVID crisis, political turmoil in different parts of the world, climate events, etc. put more emphasis on the importance of sound credit risk management solutions as the task becomes more and more complicated in the world of growing uncertainty and challenges.
We at FS Impact Finance have been closely engaged in the monitoring of credit risk both on the level of individual partner institutions and on portfolio level. And over the years of my working experience, I have observed the growing importance of credit risk management in the field of microfinance, as well as in its wider implications in the world economy. As straightforward as it might look at first glance, the measurement of credit risk has grown substantially more complicated in recent years, especially with the complication of credit instruments.
What is Credit Risk?
- Market risk vs credit risk
- Types of credit risks
In finance there are many definitions and classifications for risk, and it is difficult to come up with a best way of describing it due to its manifold implications and perspectives. In a most broad sense, risk is the uncertainty that actual results will differ from expected results. Usually when discussing financial risk, we distinguish between market risk, referring to the possibility of losses due to changes in the prices of financial assets and credit risk, referring to the possible failure of a counterparty to make a contractual payment. However, we should notice that these two types of risks can be intertwined in their practical applications, and sometimes it can be difficult to find clear-cut lines between the two.
E.g., a corporate bond carries both types of risks because its value is sensitive both to interest rates and to the creditworthiness of the issuer. Also, we should consider that changes in the market value of a firm’s assets may also affect its ability to pay its debt which makes the aforementioned concepts closely interrelated.
Without diving deep into the details of risk taxonomy, it is worth noting that Credit Risk can be viewed from single transaction perspective and overall portfolio perspective.
From single transaction perspective we are looking into the standalone probability that the individual borrower will be able to repay, while from portfolio perspective, we are dealing with the probability of loss of all borrowers, with consideration for correlations between individual borrower defaults, the effects of diversification, the cyclicality of collateral values, etc.
There is no comprehensive list for all the types of credit risk as the classification of risks largely depends on the given scope and perspective, however, some common types are described as follows:
- Credit default risk is defined as the risk of loss arising from a debtor being unlikely to pay its contractual obligations in full (a.k.a. Counterparty risk).
- Concentration risk refers to additional portfolio risk resulting from increased exposure to one obligor or groups of correlated obligors (e.g., by industry, by location, etc.).
- Credit spread risk is typically caused by the changeability between interest rates and the risk-free rate of return.
- Country risk is prominently associated with the country’s macroeconomic performance and its political stability.
Credit Risk Management & Evaluation
It is important to be able to quantify the given information to arrive at reasonable interpretation for the measurement of credit risk. Usually, credit risk management comprises the stages of identifying, monitoring, and controlling of risks. However, we should bear in mind that this is a continuous process with rather interrelated than independent stages of implementation. So, from one institution to another, how these stages are classified and tailored to the working practices can vary. Nonetheless, a sound framework of credit risk management is of vital importance for all financial institutions, including such elements as:
- Know your customer (Pre-loan risk assessment) – dealing with the client’s identity, financial situation, risk tolerance level and other related information which should be available to identify and assess potential sources of risk.
- Internal credit rating – credit scoring models and internal ratings are used by lenders to determine borrowers’ potential probability of default (PD), loss given default (LGD) and exposure at default (EaD).
- Credit administration – standard operating procedures should be in place to check the terms of approved credit applications as well as credit-related contracts and to keep the information in the credit system up to date.
- Risk limit management – preventing credit assets from highly concentrating in a particular customer or sector. Such limits are set for individuals, institutions, affiliates, group enterprises as well as for specific sectors and countries. They are designed to manage the concentration risk by reducing the potential impact of an adverse chain reaction that a single event or a sudden change in the economic conditions may cause.
- Early warning and monitoring – regular reviews of outstanding loans and reporting procedures for material events help prevent or stay on top of changes in the quality of credit assets. Guidelines are defined for monitoring early warning signals to effectively control credit asset quality.
In the context of credit risk evaluation, we can distinguish qualitative and quantitative techniques, which are further explained in more detail.
Qualitative Credit Risk analysis
Qualitative credit risk analysis uses subjective judgment based on non-quantifiable information, such as management expertise, industry cycles, ownership structure, core business and other factors which address the obligor’s willingness to pay.
In financial literature there is quite a popular methodology known as an acronym of 5 Cs which takes five categories starting with the letter C for the analysis of credit risk. These five categories are briefly described below:
- Character refers to the obligor’s level of responsibility, honesty, serious intention to repay the loan.
- Capacity assesses the financial condition of the obligor and their ability to properly repay the loan.
- Collateral assesses the real cover for the loan.
- Capital or cash assesses the ability of the obligor to generate enough cash flows to repay the loan.
- Conditions refers to the macroeconomic or industrial circumstances that affect the obligor’s ability to repay the loan in time, i.e., the impact from the external environment.
Quantitative Credit Risk analysis
Quantitative credit risk analysis deals with historical, current, and forecasted figures from the financial statements including but not limited to the balance sheet, income statement, and cash flow statement.
Some limitations of quantitative analysis are the historical scope of financial statements and lack of details. Also, since past performance cannot be extrapolated into the future with certainty, we should note that figures of past performance are only estimates of the borrower’s future ability to pay. Moreover, financial reporting guidelines are developed by multiple parties with diverse interests and there is some discrepancy regarding how financial information is reported subject to established accounting rules and national standards.
So, the bottom line is that financial statements have their shortcomings and credit analysis should always combine quantitative techniques with qualitative judgments which are implemented throughout a detailed due diligence process.
Given a great variety of definitions and classifications for risk in financial literature, it is important to understand and evaluate the concept in its practical implications. Credit risk remains a focal point for financial institutions
Sound credit risk management mechanisms and a strong framework are key for financial institutions dealing with the risk of potential losses due to borrowers’ failure to repay a loan. The quantitative measurements of credit risk will be discussed in Part 2.