Question

Define credit risk. Explain the three core issues to be considered when evaluating the credit exposure associated with a single counterparty.

Answer 1

Credit risk basically the risk associated with providing loan to a borrower and their ability to repay back the principal amount along with the interest arising time to time.Credit risk is associated with every lending done by the banks and financial institutions. Therefore before granting a loan, a thorough analysis of the background of the borrower, the capacity to pay, the financial condition, the cash flows and the collateral security to be taken as mortgage all are assessed and contract is made accordingly. Any failure to meet the parameters set by the credit institution would result in refusal to grant the debt.

THE CORE ISSUES TO BE CONSIDERED WHILE EVALUATING THE CREDIT RISK:

1)Background or character of the borrower: This involves an assessment of the trustworthiness, stability and financial conditions of the borrower to know the money is provided in the safe hands and he would seriously make efforts to multiply them by his ideas. The person willing to take loans is granted after a background check of his credentials, plans, references is made. If at any point, it is unsatisfactory, the application is refused.

2) Capacity to repay: This involves a measurement of the credit score, the debt and liquidity ratios of the financial statements submitted by the borrower, the past loans and their repayment conditions. At this point the banks provide a go ahead only if the applicant suffices to the ability to make timely repayments. Most of the businesses do not generate income from the initial period but interest obligations has to be met.Hence, it is ensured

3)Collateral: Money is valuable and hence lender wants to check on the collateral security to be taken in case of default in repayment occurs. Collateral security means the security which the bank will keep in case the borrower makes continuous default.This includes the personal assets or existing business assets which are of a recoverable value .