What happens when, after contracting a financial product, the investor does not recover the investment in the time and installments established in the contract? What happens at that time is what is called “credit risk”, that is, the probability that one of the parties to the financial product contract will default on its contractual obligations when it finds itself in a situation of insolvency or inability to pay. Due to this breach, it will produce an economic loss to the other party.
Although traditionally this phenomenon has been related to financial institutions
It can also be extended to companies, individuals, financial markets and organizations in other sectors. For example, when companies finance a product to their customers, when suppliers charge thirty days or when an investor buys a bond: they all have the risk of not receiving the amounts stipulated in the contract in the established time.
On the other hand, market risk (which also includes currency, price, volatility risk, etc.) has a systemic risk component, that derived from the global uncertainty of the market that affects more or less lower grade to all the existing assets in the economy and that cannot be completely eliminated.
Types of credit risk
As we have seen in previous lines, credit risk can occur both in financial institutions and in companies, markets or government agencies. Likewise, it can be supported by different economic agents, on which credit risk can be defined. Credit risk on companies: this risk occurs when, after the sale of a product in installments, the customer falls into default. To avoid this type of situation, what should be done is to hire an external service that is in charge of studying the credit risk of the customer who has requested the installment payment.
Credit risk on individuals
all of us bear the credit risk in many of our daily activities, from depositing our savings in a financial institution to working for others or carrying out larger investment operations. However, a series of legal measures have been established that limit this credit risk of individuals. In the case of bank deposits, there is the Deposit Guarantee Fund (FGD), and in the case of non-payment of wages, the Salary Guarantee Fund (FOGASA) has been created.
Credit risk on financial institutions: the financial product that is most exposed to credit risk is the loan, whether it is aimed at individuals or companies. For this reason, financial institutions usually carry out very exhaustive credit risk studies and include additional clauses in contracts such as the assignment of personal guarantees that, in the event of non-payment, cover the amount owed.
There are two large credit risk groups in a financial company that report directly to the counterparty
On the one hand, retail credit risk, which is the one that originates mainly from the financing activity of individuals and SMEs, such as loans, credits or any financing activity related to them. On the other hand, there would be the wholesale credit risk, which is somewhat more complex by including the counterparty risk, which may come from financing activities or from the entity’s own activity when carrying out a sale or merger and acquisition operations. .
Example of credit risk
Next, we are going to see a series of scenarios in which credit risk models are reproduced.
Default or default risk: this is the risk that is generated when the person to whom a loan is granted does not fulfill its obligations when repaying it.
Credit downgrade risk: This type of risk is also known as a migration or downgrade risk. It refers to the risk that rating agencies lower the value of a loan.
Exposure risk: in this case, it refers to the risk that exists on the payments that the creditor must make in the future.
Credit spread risk: specifically, it is the risk that the yield of a bond increases in relation to another that has the same maturity date.
Credit risk assessment: how is credit risk calculated?
Once we have established the concept of credit risk and the different types that exist in the financial market, we are going to see how to evaluate, in a very simple way, the credit risk of an operation.
To do this, we will need to manage the following variables: the concept of expected loss, loss in the event of default, exposure to default and the probability of default or default.
- Probability of default (PD): PD (Probability of default) is a credit rating measure that is awarded to a client or contract with the aim of estimating the probability that it will default on payment in one year.
- Exposure to default (EAD): the EAD (Exposition at default) is another of the necessary indicators in the calculation of the expected loss and capital. It is defined as the amount of debt that is pending payment at the time the customer breaches the contract.
- Loss on default (LGD): Severity or LGD (Loss given default) is another key metric in risk analysis and is defined as the percentage of exposure at risk that is not expected to be recovered in case of default.
Thus, the credit risk indicators that we are going to use to generate our formula are the following:
Expected Loss = Probability of default or probability of default risk (PD) x Exposure to default or position value at the moment of default risk (EAD) x Loss in case of Default (LGD).
Formula: PE = PD x EAD x LGD
Finally, we are going to see a practical example so that the calculation is seen more clearly. Imagine a person with a mortgage of 300,000 dollars, with an interest of 4% at 30 years. The risk department determines that there is a 2% possibility of default at 30 years. In addition, it estimates a recovery of 60%, which means that 40% will be lost. Therefore, applying our formula, the expected loss would be:
PE = 0.02 x 300,000 x 0.4 = $ 2,400.
Now you can get a more complete idea of what a credit risk entails, as well as the credit model policies based on these risks.
One way to minimize the impact it may have on your business organization or your financial investments is to anticipate a possible default situation on the payment of a loan and mortgage to find financing options that less affect your financial stability. A good option may be to request a personal credit online. The advantage of these loans is that by completing a very simple procedure through the internet you can instantly access a credit line of up to 5000 dollars. In the case of Creditea, in addition, you can establish very flexible payment installments that adapt comfortably to your financial situation or that of your company.