October 15, 2022 •
Risk, in any shape or form, is a part and parcel of our lives. The possibility of certain circumstances suddenly changing our daily routine without warning is always there, whether we like it or not. However, it’s better to focus on what we can do to mitigate or reduce the impact of certain risks.
In the realm of finance and funding, the term credit risk and credit risk management often crop up in conversations. Let’s explore what is credit risk and credit risk modelling and how they can be managed, and more!
What is Credit Risk?
Credit risk is a term that is mostly used among banks and financial institutions. It defines the probability of any loss that a lender might face if the borrower defaults on a loan. It is a chance all lending institutions have to take with any loan or debt provided to borrowers.
Credit risk is calculated based on a borrower’s ability to pay back a loan based on the original terms of repayment. The factors that form the basis of credit risk include the 5 Cs of credit. Let’s explore them further.
Also Read: How to improve your CIBIL score to avail a loan at lower interest rates?
The 5 Cs of Credit
- Character - Character refers to the profile of the borrower. If you are applying for a Personal Loan, lenders would like to know your personal and financial background as well as your credit history. In case of businesses or firms, lenders will look for the credibility or reputation of the company.
- Capacity - Capacity refers to the ability of the borrower to take and repay the debt or loan received from the lender or lending institution within the stipulated terms. In the case of a commercial borrower or a business entity, it refers to its capacity to repay the debt that will depend on its ability to generate steady cash flow and profits.
- Capital - Capital is used to determine a borrower's overall financial strength or ‘wealth’, which further establishes their ability to pay back a loan. Lenders also check if the borrower has alternate sources of funds to pay back their debt.
- Conditions - Conditions refer to the purpose as well as the circumstances or external forces that may pose some risk, threat, or opportunity for the borrower. Conditions for business entities could be comprised of industry-related challenges or technological developments.
- Collateral - Collateral is any asset held by a borrower that can be used or put up as security against a secured loan.
Credit Risk Management
Credit risk management refers to the practice of mitigating potential risks and losses that a lender or lending institution might face while lending to high-risk borrowers. It involves the assessment or measurement of risks involved and evaluating different scenarios that could lead to a favourable outcome for both the lender and the borrower.
Let’s learn more about the six key elements of credit risk management.
The Six Main Elements of Credit Risk Management
- KYC - KYC or Know Your Customer is a streamlined process across all banking and Non-Banking Financial Companies (NBFCs) that allows them to filter out wrongful funding and money laundering cases. It involves a set of important documents that provide all the required information of a borrower or customer to the financing company to verify their background and identity.
- Creditworthiness Assessment - Once the KYC is done, the lenders assess the creditworthiness of a potential customer or borrower to determine if they are capable of paying back their debts or dues on time. This step is crucial as it allows lending institutions to ensure that the credit background of those they are lending to checks out.
- Quantification of Risk - Quantification of risk means figuring out the risk probability or the probability of a borrower defaulting on their loan. This element is crucial as it further establishes the overall pricing and credit terms of the loan. The process involves determining the probability of default, the loss given default, and the risk-adjusted return on capital.
- Decision-making - The final decision on credit lies with the bank, lender, or lending institution. This is important as borrowers applying for funds via loan may require them quickly, leaving a very small window for financing establishments to approve and disburse funds within a short period. However, several banking and non-banking financial companies (NBFCs) nowadays have an automated process that makes the entire experience quick and hassle-free.
- Calculation - Once the final credit decision has been made, the total loan amount and interest rate are calculated based on the creditworthiness of the borrower and their ability to fulfil the terms of credit as laid out by the lender or lending institution.
- Monitoring and Review - After the loan pay-out is done, it is still essential for banks and financing companies to monitor and review the financial growth and repayment activities of the borrower and that they repay the loan within the stipulated time. Doing so also allows lenders to identify any chances of default and alert the borrower before it happens.
All of the aforementioned elements of credit risk management ensure an efficient credit collection process that benefits both the lender and borrower in the long run.
Also Read: How to Get Out of a Financial Crunch in Business
Managing Credit Risks with Easy Loans
These days, many banks and NBFCs offer easy access to Business Loans for commercial borrowers and enterprises, making the entire loan processing experience smoother for all involved.
These Business Loans, especially the ones offered by financial institutions like Poonawalla Fincorp are financing products that are designed to benefit both the lender and borrower with easy-to-understand terms & conditions.
- Credit risk is a part & parcel of the loan process and is something that all financing establishments need to account for before providing loans.
- Credit risk management can be effectively performed with its six main elements that work in tandem to ensure that neither the lender nor the borrower faces any losses.
- Both lenders and borrowers can mitigate credit risks with instant Business Loans.