ABCAdda | Updated Jan 09, 2023
What are the three types of credit risk? The three types of credit risk include credit default risk, concentration risk and country risk. Credit risk typically occurs due to a borrower defaulting on the loan payment. Banks often face large credit risks if they don't evaluate a borrower's creditworthiness.
The 5C's of borrower, character, capital, capacity, collateral, and conditions are verified to mitigate the credit risk.
This blog will explain what credit is, the importance of credit analysis, the risk associated with lending loans, and how to calculate and mitigate financial risk.
Credit is the process involved in borrowing money from an organization/person with the understanding that the amount is repaid later fully with interest.
Credit analysis is the process done by an organization/bank when lending a loan to a company or a person. A credit analyst normally does credit analysis before approving a loan to a customer or a company.
Credit analysis tells the ability of a person/company to repay the loan based on evaluating their earnings and assets.
Credit risk involves the borrower's inability to repay the loan on time. Insurance companies may also face credit risk due to the promise of paying a higher amount to their customers.
The risk occurs when a borrower fails to repay the loan 90 days past due time. Credit default risk may severely impact the borrower's loans, assets and derivatives.
Concentration risk mainly affects the banking sector, which arises from concentration to a single counterparty, sector or country.
Country risk occurs when a nation severely suffers from political, climatic, and social risks. Country risk credit rating determines the country's risk. It depends entirely on the investor whether to face the risk or not.
Most lenders have their procedures for doing credit analysis. But most lenders look at the following 5 Cs to reduce credit risks. The five stages of credit analysis include:
The capacity talks about the borrower's ability to repay the loan by considering various factors like a person's income, expenses, cash flow, debt-to-income ratio, debt-to-equity ratio and repayment timing.
When a person's debt-to-income ratio and debt-to-equity ratio are less, there are more chances for approval of a large sum as a person has a relatively low amount of debt.
When you apply for a bank loan, the bank officer looks at whether the person invested his savings in the startup business, as this shows how serious a person is about his business.
Collateral involves an alternate/backup source to repay the loan, like a home, gold or land. Bank officers must approve a loan to the individual only when the borrowers put in assets to secure the loan.
The lender wants to know whether your business has enough reputation in the market. So, while applying for a loan, mention your business plan that can withstand competition from other businesses.
Before granting a loan, lenders normally look at a person's character and creditworthiness. Character is something you can never buy; it is built within everyone. A person's commitment to repaying a loan helps in granting additional credit.
We hope our article on "What are the three types of credit risk" has given the answer you are searching for. This article clearly explained credit risk and measures taken to reduce financial risk. So, here is the end of our article.