What is a credit risk? A credit risk is the actual risk of default by a borrower failing to meet required monthly repayments on a loan. At the first Resort, the most severe risk is the bank risk and entails total loss on interest and principal, interruption to essential cash flows, and possible collection litigation. The loss can be partial or complete.
The bank’s risk can extend to other financial institutions if a consumer fails to meet credit card repayment obligations. These institutions are not banks; they are credit card companies. Credit card companies bear only a portion of the credit risk. The portion allocated to the bank is based on the credit risk of each institution, as determined under the guidelines established by the Federal Reserve.
As a consequence, even when interest rates are reduced to zero, credit card companies can still take a loss on all unsecured loans. Credit card companies use complex risk management techniques to keep credit card balances low. For example, they limit the number of credit cards that a consumer can hold at one time and subject those customers to high charges for holding more than one credit card. They also charge late fees and charge certain percentage points for balance transfers. All these fees add up to a large sum in profits for the credit card companies.
A second type of credit risk involves the lenders themselves. A bank is an organization that owns and manages the physical property. It does not own the land or buildings that it uses to create and maintain its money. The institution lends its money to individuals, businesses, and other entities. If the loan goes into default, the primary loss by the bank is the funds itself, not the property.
A business is an entity composed of individuals working together. A business enterprise exposes its risk to risks in two ways: personal risk (the risk of damage or loss to an individual’s property) and business risk (the risk of damage or loss to an entity). Since individual and business credit are somewhat related, a bank that facilitates both kinds of credit will have a somewhat mixed credit risk portfolio.
Business credit carries a different kind of risk. A business enterprise exposes its risk to risks in two ways: tangible assets and intangible assets. Tangible assets are those assets that can be physically damaged or destroyed. Examples of tangible assets include inventory, fixed assets such as equipment and furniture, accounts receivable, and capital goods. In addition, a company’s credit may be used to obtain credit from other sources. These sources of credit include lending institutions, other businesses, and even government agencies.
Intangible assets, on the other hand, are those assets that cannot be physically destroyed or damaged. Examples of intangible assets are goodwill, accounts receivable, and capital assets. When assessing credit risk, a bank would attempt to determine the probability that a business enterprise will have negative amortization exposure, which means that the amount it must pay out to get rid of existing debts. Also, if a business enterprise does not generate enough cash flow to repay its debts, then it runs the risk of being forced into bankruptcy. A bankruptcy will damage the company’s creditors and stockholders and will cost the business owner millions of dollars.
In order for a business to successfully manage its risk and reduce its credit risk, it should first identify the types of risks it faces and then develop an effective, risk management strategy. In addition, it should continually review its risk management policies and procedures to make sure that it is still effective and appropriate. It should also keep a watchful eye on industry trends to determine whether there is a possibility that the business will experience credit risk. Credit risk management is very important to every bank in the business of lending money. It ensures that the bank will not be on the wrong side of its customers’ pockets when they spend money with the bank.