What is credit risk? Definition, types, and examples

As a company grows, credit becomes an increasingly important part of business operations. When a business applies for a loan, lenders assess the organization’s creditworthiness and credit risk before they lend it funds.

In this article, we’ll define credit risk, give some examples, explain the main types of credit risk, and provide detailed insight into how lenders calculate credit risk before extending credit.

What is credit risk?

Credit risk is calculated based on the borrower’s likelihood to repay a debt according to its initial terms. Because lenders want to reduce their financial losses as much as possible, they may decline a loan to a borrower they’ve determined is too risky.

Credit risk can also apply to similar financial situations—for example, the risk that an insurance company may be unable to pay a claim, or a bond issuer fails to repay bondholders.

What is an example of credit risk?

Suppose a bank lends money to a small business owner for expansion. The loan requires monthly payments over 10 years. Consider these two potential outcomes:

1. The expansion fails, revenue drops, and the business owner defaults on the loan. In this scenario, the credit risk is realized, and the bank is at risk of losing the money it lent.
2. The business’s expansion succeeds, and the owner repays the loan on time and in full. In this scenario, the credit risk is mitigated for the bank.

Essentially, the bank's credit risk hinges on the success of the business owner's expansion and their ability to make timely loan repayments.

What are the main types of credit risk?

The three main types of credit risk are credit default risk, concentration risk, and country risk. However, there are other types of credit risk as well, each with unique implications:

1. Credit default risk

This is the most common type of credit risk. It occurs when a borrower fails to make their loan payments in full or is 90 days overdue on their loan payment. Default risk can fluctuate based on the broader economic climate or the borrower’s particular financial circumstances, such as a drop in revenue due to increased competition or a recession.

2. Concentration risk

When a financial institution concentrates much of its lending on a single borrower or specific industry, it increases the risk of default or losses. The risk here is due to the fact that the lender’s portfolio lacks diversification; if the borrower or industry experiences a financial downturn, then the lender stands to incur significant losses.

3. Country risk

This type of credit risk refers to the probability that a country won’t be able to meet its foreign currency payment obligations. Also known as sovereign risk, country risk is based on political instability, economic performance, exchange-rate concerns, and regulatory risks that may impede a lender’s ability to recoup their investments in foreign interests.

Other types of credit risk

In addition to the primary types of credit risk, there are a couple others worth reviewing:

Institutional risk

Lenders can face institutional risk in several ways. For example, if a bank is perceived as unstable, it may face institutional risk if it experiences a run on deposits. Institutional risk may also result from a breakdown in regulatory or legal structure, or if an entity responsible for supervising a loan agreement between a borrower and lender faces issues.

Downgrade risk

This type of risk results from the possibility that a credit rating agency will downgrade a borrower’s credit rating. A higher risk of downgrade leads to a higher risk of default, which makes the borrower unattractive to lenders.

Calculating credit risk

When lenders assess the risk of extending a loan to a business, they perform a credit risk analysis using several factors, including credit score, income level, and past loan history. The resulting credit risk score—also known as a risk profile—gives lenders important context around how likely the company is to pay back the loan.

One popular formula for measuring credit risk that lenders use is:

Credit Risk Score = Default Probability x Exposure x Loss Rate

This is broken down as follows:

• Default probability measures the likelihood that a borrower will default on their loan. This is calculated by reviewing the borrower’s credit score, income level, and past loan history.
• Exposure is the amount of money that the lender stands to lose in the event of a default. This is calculated based on the size of the loan, the terms, and any collateral provided.
• Loss rate is the percentage of money the lender cannot recoup if a borrower defaults on their loan.

The 5 C’s of credit risk analysis

The 5 C's of credit risk analysis are another common framework lenders use to evaluate the creditworthiness of potential borrowers. The 5 C’s include character, capacity, capital, collateral, and conditions:

1. Character: This refers to a borrower's reputation and track record regarding financial obligations. Lenders often perform a credit analysis and look at personal references to gauge a borrower's credit quality and willingness to repay debts.
2. Capacity: Credit officers assess a borrower's ability to repay a loan by comparing income against recurring debts and measuring the borrower's debt-to-income ratio.
3. Capital: Lenders also consider any capital the borrower puts toward a potential investment. A large contribution by the borrower will lessen the chance of default.
4. Collateral: Collateral includes assets, like real estate or a car, that can secure the loan. Lenders will perform a collateral valuation and may offer better terms if the loan is secured against valuable assets.
5. Conditions: This refers to the economic and industry conditions at the time of the loan, which could affect the borrower's ability to repay their debt.

What is credit risk management?

Credit risk management refers to the methodology financial institutions use to evaluate and mitigate the credit risk presented by potential borrowers. The Basel Committee sets regulatory standards that commercial banks can use to assess risk.

The process uses credit scoring models designed to minimize the likelihood that a borrower will default on their loan payments, including assessing a borrower's creditworthiness and liabilities, monitoring loans closely, and ensuring that borrowers make payments on time.

Some methods lenders can use to manage credit risk include:

Financial risk analysis

Financial risk analysis involves assessing a borrower’s ability to repay the loan, including their current financial health, future cash flow projections, and credit history. This risk measurement helps lenders decide whether or not to approve the loan.

Credit risk assessment

This involves credit risk modeling to evaluate the borrower’s probability of default and any additional risks associated with the loan. Risk modeling includes assessing factors such as market volatility, competition, and liquidity. Lenders also review their internal policies and procedures to determine the risk associated with a loan.

Credit risk monitoring

Lenders must also monitor loans closely to ensure they get paid on time and in full. This includes regular contact with the borrower and, if necessary, taking action to recover past-due payments.

Credit risk stress testing

Credit risk stress testing is a method financial institutions use to evaluate the impact of adverse economic scenarios on their credit portfolios. It helps them understand how robust their credit risk management strategies areand ensure they maintain adequate capital buffers against possible losses.

There are several methods used to manage credit risk. These include:

• Portfolio management: Loan issuers spread out their investments across different industries and borrowers to minimize potential credit losses in the event of a default.
• Collateral: Creditors can require the borrower to provide collateral such as property or other assets to secure a loan. This provides an additional source of repayment in case the borrower defaults on their obligations.
• Risk-based pricing: Lending entities charge different interest rates based on the risk associated with the loan. Higher-risk loans will typically have higher interest rates.
• Guarantees: Lenders can also require the borrower to provide a guarantor to back up their loan payments in the event of default.

The business impact of credit risk

Credit risk can have a major impact on your business, as well as on financial institutions and the greater economy. As a business owner, a high risk profile can lead to less favorable interest rates, lower credit limits, reduced access to funding, or having your loan applications rejected outright.

Effective credit risk management is important for mitigating these impacts and ensuring the long-term viability and success of your business.

Ramp: Your partner in credit risk management

Ramp’s modern finance platform helps you understand your credit risk and provides in-depth insights into your financial statements.

Our expense monitoring features, coupled with automatic bill pay, can help you stay on top of loan repayments to build a strong business credit history and reduce your credit risk score.

Learn how Ramp’s expense management software can fit into your accounting operations.