As you may have been discovering in our latest articles, whether you are a private user of our page or an entrepreneur, with our blog posts you will be able to master key elements by which the market is governed. Among these, a section must be dedicated to credit or credit risk, without a doubt, one of the most important variables to consider when granting a loan.
Therefore, whether you are a client or a financial professional, in this article we are going to find out exactly what credit risk is, what connotations it implies in decision-making and what are the types that usually occur. Continue reading and find out.
What is credit risk?
Credit or credit risk is the possibility that the borrower does not comply with its payment obligations or, in other words, that a financial institution does not recover the money lent. Therefore, credit risk is a fundamental variable in the world of economics for both financial institutions and borrowers, since it directly affects the cost and conditions of loans.
Knowing the theory, if we put this into practice it would consist of mitigating those losses taking into account the solvency of the entity and the reserves that it has against losses. Hence, this risk is related to the company’s problems individually, contrary to what would be the market risk, which we will see later and which has a more systematic implication.
What types of credit risks exist?
Before talking about the differences between credit and market risk, it is convenient to first address the types and phases of the first one, as it will help us to have a more global vision of possible contingencies. Among them:
- Default risk: This is the most common type of credit risk and refers to the possibility that the borrower will not meet its contractual obligations by the agreed date. Faced with this problem, measures are presented to evaluate in time the most unexpected situations.
- Concentration risk: This risk refers specifically to the possibility that the financial institution has a large exposure to a single borrower or economic sector. If that borrower or sector experiences financial difficulties, the financial institution could suffer significant losses.
- Exposure risk: it is understood in this case as the uncertainty about the future payments that are due. This risk may be associated with the debtor’s attitude or with the evolution of market variables.
- Collateral risk: also known as the recovery rate risk, it depends on the existing debt guarantees and varies according to whether or not there are guarantees or collateral in the operation.
How to mitigate credit risks
To mitigate credit risks, it is important to implement risk management policies and procedures. As we have previously commented, this type of risk can be minimized through a preventive analysis. Among the measures we find:
– Evaluating the solvency of the borrower fundamental requirement for many financial companies. This implies determining your ability to generate income and knowing, above all, what credit history is and how it affects you. Based on this, the financial institution will establish the conditions of the product it offers.
– Diversify credit portfolios in different sectors and borrowers. This typical risk of concentration of your exposure can be minimized by diversifying your loan portfolio to reduce the risk of exposure to a single borrower.
– Establish risk exposure limits, implement credit portfolio monitoring and control mechanisms and establish provisions to cover possible losses due to non-payment.
What is market risk?
Market risk refers to the possibility that investments lose value due to fluctuations in the market. This type of risk is caused by the volatility of the market itself, which can be caused by factors such as the global economy, government policies or other events that can affect the value of investments.
Let’s take the simplest example: if you own shares in a company and the market crashes due to a severe economic downturn, the value of your shares will most likely drop significantly. This can result in considerable losses if you decide to sell your shares at that time.
Summary and conclusions
In summary, credit risk is a very important variable in the financial world since it affects the measures to anticipate the possibility that the borrower does not comply with its obligations. But it is not only a vital issue for institutions, it is also for borrowers who must present good financial health to obtain better conditions in the negotiations.
If you are interested in investigating the analysis of the possible incidents that occur in this type of process to be prevented, we recommend reading our blog article that answers the question about what a credit report is.
