Credit risk – what is that?

Few people who take out a cash loan think about the bank that grants them this loan. Meanwhile, such activities involve a high risk. Check what types of risk the bank is exposed to and how it can reduce it.

What is credit risk?

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Running a business is always risky, and financial institutions too. It is connected with the threat that the other party to the contract will not fulfill its obligations in full and within the set time. What is the credit risk? For example, the borrower repays the loan late or fails to repay part of the installments.

Put simply, by lending money to a bank, you risk not getting it back. That is why it is so important for the bank to accurately estimate credit risk in each case, taking into account the amount of the loan or the currency in which it is granted.

Types of credit risk – what are they?

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There are many types of credit risk that can negatively affect a bank’s operations. Among them stand out:

  • active (active) risk – it relates to the bank’s financial losses that result from the borrower’s failure to regulate the loan payments contained in the contract (interest, margin, commission),
  • passive (passive) risk – this is a threat earlier than it results from the contract of withdrawal of the deposited funds by the customer (their owners have sole decision-making regarding deposits),
  • individual risk (single) – applies to individual loan agreements (the borrower will not fully repay the loan or will do so at a later date),
  • portfolio (total) risk – dependent on individual risks, covers the entire loan portfolio of the bank (estimated on the basis of the number of individual loans, interdependencies between loans and the possibility of their total non-payment).

There are two more types: acceptable risk and unacceptable risk. Acceptable risk means that the level of risk of financial loss is acceptable for the bank, while unacceptable risk tells us that the level of risk of financial loss is unacceptable to the bank.

Credit risk management in a bank

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It is extremely important that the bank’s credit risk is properly assessed and reduced as much as possible. That is why banks examine our creditworthiness so thoroughly when applying for a loan.

Considering the credit risk in the bank’s operations, the client’s credit history is also of great importance for a banking institution. It speaks of diligence and timeliness in terms of settling commitments. To x-ray the borrower, banks use the credit scoring tool (see what credit scoring is and how it can be influenced).

The credit risk at the bank is assessed by each institution on an individual basis, using methods recognized by the bank.

Therefore, we as borrowers should not be surprised that when applying for a loan, we are asked to provide the required documents that allow the bank to better assess the risk associated with it.

Factors affecting credit risk

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When checking credit risk, the bank takes into account several different factors, including the type of borrower. For example, if a public finance sector entity applies for a loan, the risk associated with it is practically zero. The situation is different if the borrower is a private person.

Other factors that may affect credit risk are the borrower’s financial position and the amount of credit granted. If the client’s financial situation is very good, even when he or she applies for a high loan, then his repayment possibilities are large, so the credit risk is small. As it happens in life, this situation can change from day today.

The amount of credit risk is also affected by the purpose of the loan. It is not difficult to guess that loans for investment projects will be the most risky. When assessing credit risk, banks also pay attention to the loan term and terms.

They also do not miss the type, amount of interest or currency in which the loan was taken, or the amount of the borrower’s own contribution.

How to limit your credit risk?

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High credit risk may translate into a loss of capital by the bank, and this may lead to disturbances in financial liquidity and solvency, and in consequence, contribute to the bank’s bankruptcy. That is why banks use various methods to limit it.

Bank credit risk and methods of its reduction:

  1. Verification of the consumer’s creditworthiness – the form of employment, material situation and the history of repayment of previous liabilities are assessed.
  2. Tightening in the loan agreement – less reliable people can get a loan for a lower amount than the one they are applying for. In their case, security in the form of a mortgage or guarantor may also be required.
  3. Credit insurance – if the customer stops paying off the loan, the insurance company will guarantee the repayment of the debt.
  4. Monitoring of clients after the loan is granted – this allows us to anticipate any problems with the repayment of the loan and to start activities aimed at helping the client pay the debt.
  5. Creation of bank reserves – accumulation of funds to cover possible losses.

You, the borrower, should care about the fulfillment of the contract. Remember that non-compliance with contractual terms by bank customers can lead to higher loan costs and more accurate verification of borrowers and proposing less favorable contract terms.

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