With the online marketplace booming, consumers are becoming more demanding of instant answers or loan approvals. Banks may be struggling with delivering fast service and approvals while properly measuring risks. Risks should be properly to assign the right terms.
In today’s blog, we will cover types of credit risk, methods of calculating credit risk, and how to manage it while effectively increasing loans and profits. Every time a bank loans money, there is some element of risk. Credit risk can be defined as the possibility of a loss resulting from a borrower defaulting on a loan. Credit risk can refer to both the principal and interest a lender may not collect. This can result in an interruption of cash flows. It can also cause an increase in expenses since the bank will have to send the account to the collections department. It can be challenging for banks to determine who will default on a loan or obligations therefore they must use credit risk metrics to reduce potential risk. Loans that prove to be high risk based on metrics should be assigned higher interest rates and or lower loan amounts. This can make the potential reward outweigh the risk for the bank.
Types of Credit Risk
Rating agencies can establish credit scores for individuals that can be used by banks to help determine default risk. The two main types of default risk are investment grade and non-investment grade. These are two main categories, but sub-categories include:
- Credit Spread Risk: Credit spread risk is typically caused by the changeability between interest rates and the risk-free return rate.
- Default Risk: When borrowers are unable to make contractual payments, default risk can occur.
- Downgrade Risk: Risk ratings of issuers can be downgraded, thus resulting in downgrade risk.
- Concentration Risk or Industry Risk: When too much exposure is placed to any one industry or sector investors, or financial institutions can be at risk for concentration risk.
- Institutional Risk: If there is a breakdown in the legal structure, banks may encounter institutional risk. Institutional risk may also occur if there is an issue with an entity that oversees the contractual agreement between a lender and debtor.
How Credit Risk Can Be Calculated
While it is nearly impossible to predict who will default on loans, banks should still focus on measuring credit risk.
Credit Risk = Default Probability x Exposure x Loss Rate
- Default Probability: Determine the probability that the debtor will default on his or her payments.
- Exposure: Total amount the bank or lender expects to collect over the life of the loan.
- Loss Rate: The loss rate is simply 1-Recovery Rate. The Recovery Rate is the proportion of the total exposure that can be collected in the event the debtor reneging on payments.
- Determine borrower’s FICO score. This can help banks determine a borrower’s creditworthiness, thus allowing them to establish the potential risk.
- Calculate the debt-to-income ratio. This can help banks determine the financial status of an individual. Do they have enough cash flow to cover the monthly payment? Is there a pattern of the individual consistently borrowing more and more money? Banks should be more motivated to capture loans with borrowers that have a debt-to-income ratio less than 35%.
- Evaluate potential debt. If a borrower has three credit cards with a combined spending limit of $30,000 and a current combined balance of $10,000, the potential debt is $20,000. Banks should take into consideration potential debt when determining the credit risk.
Effective methods for measuring credit risk can reduce potential losses and help banks make better loans. When it comes to measuring credit risk, banks should focus on the five C’s: credit history, capacity to repay, capital, associated collateral, and the loan’s conditions. In our current market, banks are seeing more and more loan applications come in electronically. In order to deliver fast decisions and service to customers, most banks rely on credit risk software. Credit risk software can be customized to successfully manage risk for your financial institution.
Ways to Manage Credit Risk
One of the best ways to manage credit risk is to use a credit risk software such as GDS Link. GDS Link specializes in offering the most effective credit risk software for banks. In addition to improving credit risk management for banks, GDS Link can provide solutions, analytics, and advisory services to drive growth in lending. Implementing GDS Link can help banks lend more while reducing risk all the while delivering an end-to-end digital loan experience. Learn more about our solutions here or request a demo to get started.