What Is Credit Risk?
Simply put, credit risk refers to the possibility that borrowers or counterparties may fail to meet their financial obligations under terms agreed on in contractual obligations. Credit risk applies to everything from credit cards and home mortgages to fixed income securities and derivative instruments. Credit risk resulting from lending is arguably the biggest risk for banks, and usually the top priority of their risk management program. For purposes of this piece, we will focus on credit risk through the lens of a community bank like Merchants & Marine Bank.
Types of Credit Risk
There are three main types of credit risk:
- Credit Default Risk: Credit default risk refers to the risk that a borrower may be unable to pay their obligation in full. This type of credit risk can affect all credit-sensitive financial transactions including loans, bonds, securities, and derivatives. In banking, however, most credit default risk is centered in the bank’s loan portfolio (the term used to describe all of the loans made and held by the bank). Credit default risk is dynamic, and changes along with the fortunes of the bank’s clients and the communities it serves. This can sometimes lead to abrupt changes, like when businesses were shuttered last year during COVID-19. Credit default risk can also be influenced by changes in bank policies and risk analysis models, which we will discuss further below.
- Concentration Risk: Concentration risk arises from larger lending exposures to a single client or industry sector. Just as you’re encouraged to diversify your own personal investment portfolio, banks must be very intentional about diversifying their loan portfolios to help limit concentration risk. This can include setting limits for how much can be lent to a single borrower, a group of related borrowers, an industry sector, or even in a specific geographic area.
- Country Risk: Country risk refers to the risks arising from a foreign country taking actions that may impact the ability of borrowers to make their loan payments. This type of credit risk is often linked to political instability and macroeconomic performance, which affect the value of a company’s assets or operating profits. While many banks don’t engage in lending to foreign-based companies, the increasing globalization of our economy means that banks – and our clients – are all dealing with country risk on a more regular basis. This is especially true in areas like the Mississippi & Alabama Gulf Coast region, which boasts an impressive array of local companies that are engaged in international trade.
Credit Risk Analysis
Banks use a variety of models and tools to evaluate the risk of each and every loan application received. These models take into account factors like: the amount and type of loan requested, the value and type of any collateral offered to secure the loan, the applicant’s income available to repay the loan, and the applicant’s credit score. Additional analysis is completed on business loans, including reviewing business plans, business operations and cash flow. The results from this analysis are then compared against bank policies by seasoned credit analysts and lenders to determine whether the bank can approve the request as presented, or whether a counteroffer may have to be made. When assessing the level of credit risk, banks consider factors such as:
- Probability of Default (POD): The likelihood that a borrower will default on their loan, based on the particulars of their situation.
- Loss Given Default (LGD): The amount of loss the bank will suffer in the event that a borrower defaults on their loan.
- Exposure at Default (EAD): The overall amount of loss exposure that a bank is vulnerable to at any given time, given their total loan portfolio. EAD is evaluated through a variety of models, and the results of these models help banks set aside reserves to protect against the projected losses.
With the rapid-fire evolution of financial technology, banks are constantly developing new and better ways of identifying, measuring, monitoring, and controlling credit risk. A growing number of banks are investing in new technologies and human resources to enable more automated credit risk models that use machine learning to help increase efficiencies and support better decision making.
How Can Banks Control for Credit Risk?
Due to the nature of our business model, banks can never be fully protected from credit risk. After all, we are in the business of lending. However, financial institutions can lower their exposure to credit risk in several ways, including:
- Developing and adhering to strong policies for approving loan requests,
- Thoroughly evaluating loan requests to make sure they not only meet the bank’s criteria but also help the borrower,
- Adhering to strong standards for portfolio diversification, both by geography and by loan type, and
- By maintaining close contact with both borrowers and the markets the bank serves, so that any potential problems are spotted early enough so they can be worked through.
Stay Tuned for More on Risk Management
Stay tuned for next month’s installment, in which I’ll cover operational risk management. In the meantime, browse our resources page for more helpful information.
President & CEO of Merchants & Marine Bank