What is Credit Risk?
Amongst numerous types of risks an organisation faces, Credit Risk is the risk of default that a lender (organisation or an individual) faces when the counterparty fails to meet the terms of financial obligations. It is the possibility of losing the owed principle and interest amount, which will result in increased costs. It is calculated on the basis of the overall ability of the buyer to repay the loan. Generally, the higher the Credit Risk, the higher is the interest rate demanded by the entity for lending its capital.
Consumer Credit Risk can be measured by the 5 C’s of Credit Risk. Generally used by banks for lending out a loan and screening the loan application, NBFC and other financial services firms also use this to determine the risk associated with issuing a loan and estimating the credit-worthiness of a borrower.
1. Capacity – Measures a borrower’s ability to repay a loan by comparing income against recurring debts. It addresses the question, “Can the borrower generate adequate cash in order to repay the loans?”
2. Capital – It refers to the net worth or equity of a business or an individual. It suggests that the borrower adequately capitalised within industry standards to withstand unexpected loss.
3. Conditions – The economic, industry, and market environment can change the state of the borrower or the state of the economy. Is the borrower flexible enough to adapt?
4. Character – Moral integrity of credit applicant and whether the borrower is likely to give his/her best efforts to honouring credit obligation.
5. Collateral – Existence of assets (i.e. inventory, accounts receivable) that may be pledged by borrowing firm as security for credit extended.