Credit Risk Defined
Credit risk is an investor's risk of loss, which arises from a borrower who does not make payments as promised. This can be a consumer who doesn't make a payment on a loan, credit card or mortgage; a business that doesn't pay an employee's wages or doesn't pay an invoice when due; or even a government that does not make a payment on a bond. Analyzing credit risk is an important part of many investing decisions, and complex programs and significant resources are often used to determine whether an investor can pay back his obligation or whether he will "default" on the obligation. As such, credit risk is sometimes referred to as "default risk."
Types of Credit Risk
Many types of credit risk exist, which sometimes are referred to in specific terminology. Any increase in costs associated with a borrower not making payments as agreed can be loosely classified as credit risk. For example, even if a credit card customer does end up paying his bill, if the lender has to make collection calls or resort to a collection agency, this increase in cost is a version of credit risk. More specifically, "default risk" is the risk that the party does not and cannot pay as agreed (over and above a simple increase in collection cost) and is sometimes referred to as "counter-party risk." When the borrower is a government, credit risk is often referred to as "sovereign risk."
Credit Analysis: Advantages and Disadvantages
Firms, governments and all types of creditors engage in credit analysis to determine to what extent they face credit risk associated with their investments. In weighing the advantages and disadvantages of making a certain type of investment, firms utilize in-house computer programs to advise on reducing and avoiding risk (or transferring it elsewhere) or use third party help, like examining rating agencies' estimations of creditworthiness from companies like Standard & Poor's, Moody's, Fitch Ratings and others. After lenders use their own models and the advice of others to rank customers according to risk, they apply this knowledge to reduce credit risk.
Methods to Reduce Credit Risk
Lenders use a variety of means to reduce and control credit risk. One way lenders reduce credit risk is by using "risk-based pricing," in which lenders charge higher rates to borrowers with more perceived credit risk. Another way is with "covenants," whereby lenders apply stipulations to a loan, such as borrowers must periodically report on their financial condition, or such that borrowers must repay the loan in full after certain events (like changes in the borrower's debt-to-equity ratio or other debt ratios). Another method is diversification, which can reduce credit risk to lenders as well as a diversified borrower pool is less likely to default simultaneously, leaving the creditor without hope of recovery. Besides these, many firms utilize credit insurance or credit derivatives, such as "credit default swaps," in an attempt to transfer risk to other firms.