Question

Define credit risk? Name ad discuss at least 3 methods lending institution uses to reduce credit risk associated with the loans that they grant to their borrowers

Answer 1

Hello

Credit risk refers to the risk that the borrower of money will fail to make the required payments, i.e. the risk that the borrower will default on his payment.

Lending institutions use many methods to reduce credit risk. I'm naming and discussing the most commonly used ones:

a) Securitisation and Credit Tranches : Under this method, the lending institutions make a pool of the loans and then sell their related cash flows to the third party investors as securities such as bonds and pass-through securities by framing various tranches to the bonds and selling those tranches at different interest rates and hence generate a ready cash flow to the institution. These bond's cash flows are met using the cashflows from those loans as those loans, more often than not, enjoy the diversification benefits.

b) Tightened Covenants : A covenant is a legally-binding document agreed on, between the borrower and the lending institution. It defines the rights and duties of each party and hence is quite detrimental when either one of the party is going to default on his/her payment. If the lending institution is of the slightest doubt that the credit risk may arise in future, the institution should tighten the documents by using stricter negative/ restictive covenants and by increasing positive covenants. For e.g.

(i) Lending Institution may require the borrower to submit their quarterly results and reports so that the institution can keep a strict eye on the financial position of the borrower.

(ii) Lending institution may keepa clause to force the borrower to pay the loan in full, on the occurance of certain events, such as change in interest coverage ration/ debt-equity ratio.

(iii) Lending Institution may restrict the borrower from paying dividend, buying back shares, further borrowing or alike corporate actions which may affect negativelly the financial statements of the borrower.

c) Credit Derivatives : Lending institution may use credit derivatives to hedge the risk of non-payment of loan dues. The mosot commonly used derivative of this category is credit default swaps.

d) Collateral Requirements : Lending Institutions can significantly lower their credit risks by requiring collaterals for loans and/or refraining from lending to people with bad track record and setting up a higher collateral ration requirements for lending.

I hope this solves your query.

Do give a thumbs up if you find this helpful.