Most people are aware of the fact that taking out a loan is a significant risk, even if we are sure that we can afford it. We are not able to predict whether, for example, we will not get sick or lose our job, which will result in problems with settling the liability.
Few, however, remember that a loan is also a high risk for the institution that grants it. Credit risk is a relative niche concept that is undoubtedly well known to bankers and, in general, to people employed in the financial sector, but for the average bank customer, it may be more mysterious than, for example, creditworthiness or credit history. It is worth expanding your knowledge on this subject, because the awareness of how the assessment of credit risk is carried out and what it consists of may be useful in life. So what is credit risk and what is it for? What does it mean exactly? How is credit risk assessed and why is credit risk management so important?
What is credit risk?
It would seem that banks are inviolable institutions that are not threatened by anything. The reality, however, is that banks’ activities involve many different types of risk that can significantly affect the income they generate. The most important of them are:
interest rate risk
Market risk, as the name suggests, relates to a market situation that is not largely influenced by banks, but which may turn out to be crucial for their activities. A sudden increase in inflation or unstable economic situation (for example due to social unrest, war) is just some of the many factors that may cause a sharp increase in market risk.
Operational risk relates to unfortunate situations to which banks are exposed in the course of their normal activities, such as theft or unintentional employee error. This type of risk can be reduced by investing in good security systems and adequate staff training, but it cannot be eliminated.
The risk of insolvency, as the name suggests, is related to the possible insolvency of the bank itself or organizations and companies cooperating with it.
Interest rate risk is directly related to the issue of currency value (and therefore also, as in the case of market risk, for example, the occurrence of inflation). It may turn out that suddenly the value of money has significantly decreased or increased, and therefore the previously granted loans have become much less profitable for the lender. As you know, banks grant loans using two types of interest – fixed and variable. Especially the fixed interest rate is a considerable risk for the bank. Why? At the time of loan repayment, the market situation may change significantly and the fixed interest rate, which was previously favorable for the bank, will not necessarily continue to be the same as a result.
So what is credit risk? It is a risk that is associated with granting a loan for the bank and to put it even more precisely – the risk that the customer turns out to be insolvent and will not be able to meet the terms of the concluded contract. Considering that banks earn the most money from contracts with customers, high credit risk can have catastrophic consequences for them. They are divided on the risk of total and risk single.
We must remember that granting a loan is a source of income for the bank, and to achieve it, it must first invest a lot, i.e. provide the borrower with the amount of capital he wants. The failure to repay the loan on time does not mean only that the bank is not gaining, but also that it is losing.
Single and single credit risk
As mentioned above, there are two types of credit risk: total risk and single risk.
Single risk, as you can easily guess, refers to the risk involved in lending to individual clients. One customer who does not pay the liabilities on time is not a big financial burden for the bank, especially when it comes to a loan for several thousand zlotys with a turnover of several billion.
The cause of difficulties in repaying the loan by a given person may be, for example, illness or job loss, i.e. things beyond the bank’s control.
The occurrence of such customers is inevitable, even with first-class algorithms and experienced analysts deciding who will be granted credit to avoid such a situation. Losses related to the insolvency of individual units are inherent in the bank’s activities and cannot be completely avoided, therefore, individual risk in itself is not a great threat to banks.
The overall risk relates to all loans granted by the bank. It is not a problem when a small percentage of customers do not fulfill their contracts, but when that number starts to rise, a bank can quickly default. The increase in the total risk may result, for example, from the imprecise assessment of creditworthiness, which results in granting loans to many unreliable customers. Too high a total risk means that potentially many clients may not pay their liabilities on time, which will be associated with financial problems for the bank.
While the single risk is often independent of the bank, it has a much greater impact on overall risk. It can be limited, for example, by not granting credit to people who are likely to experience problems with debt settlement.
Sometimes it is also referred to as passive risk, also known as passive risk. However, it does not apply to loans, but to deposits and other types of deposits, namely that the client decides to withdraw funds faster than it would be optimal for the bank. After all, all the time our funds are deposited, they are in practice held by the bank and used by it for a small fee.
Credit risk – summary
As you can see, credit risk is a very important concept – not only for banks for which too high risk may mean a loss of financial stability but also for customers. Credit risk assessment related to granting a loan to a given application is crucial as regards whether we will receive the said loan. The truth is that just as for us, taking loans is always a bit risky, and granting them is also risky for banks. Even if we are in good financial condition when we commit, everything can change very quickly. A small group of customers who fail to meet their contracts is not a threat to the bank, but when their number grows, it is already a symptom of internal problems, be it in terms of procedures or the human factor.
It cannot be denied that when it comes to calculating the risk, banks and loan companies face a very difficult task. On the one hand, they cannot be too demanding on customers, because then no one will be able to meet their requirements and they will not be able to earn money. On the other hand, a significant relaxation of the requirements can also have a very negative effect if some customers turn out to be unreliable.
Credit risk management is a priority for banks, which means that they invest a lot of time and resources in it. This is not an easy task, because, on the one hand, the bank cannot refuse anyone who is not an ideal candidate for a borrower if they want to earn, and on the other – it cannot risk too much and give too much credit to insecure people.
Credit risk assessment in each bank is slightly different, but we always deal with very advanced algorithms and extremely extensive databases. We can therefore feel that we do not influence our result, i.e. credit scoring. However, this is of course not true. If we care about it, improving our scoring is within our reach, although of course it probably won’t be quick or easy.