What is credit risk?
Credit risk management is an essential undertaking for any business offering credit; without applying effective credit risk mitigation techniques, a company that offers credit or loans will struggle to thrive and survive.
But what is credit risk in simple words, why is it necessary and how is it assessed?
What is credit risk?
One would define credit risk as the possibility [risk] of a borrower failing to repay a loan to a business, as per the terms of their credit or loan agreement.
Managing credit risk is essential as without credit risk analysis, too many high risk borrowers could ‘slip through the net’ who would likely default on their loan or credit repayments.
Credit risk solutions are put in place to avoid a lender’s sales and cash flow being heavily impacted by borrowers not repaying their principal and interest.
Historically, some businesses that have been negligent in the effective management of credit risk have ended up bankrupt.
The types of business who provide credit to consumers and who are vulnerable to credit risk include:
Banks and building societies
Credit card companies
Trading businesses (offering buy now pay later deals)
How companies minimise credit risk
Credit rating checks
To assess a borrower’s creditworthiness, lenders will use credit rating agencies.
Lenders will look at a customer’s credit rating with the UK’s three main consumer credit agencies: Equifax, Experian and TransUnion.
Each credit reference agency (CRA) has a unique credit score as they all use different techniques to calculate their agency-specific credit rating.
In addition, different lenders will use different agencies or more than one agency to assess a customer’s creditworthiness.
To assess the credit risk of countries or private enterprises, lenders will use the three main commercial credit agencies: Moody’s, Standard & Poor’s or Fitch Group.
Due diligence checks can also include analysis of financial statements, director searches, assessment of trade payment performance data and a reputation check with a customer’s supply chain.
Asset portfolio allocation
Managing credit risk is vitally important to the financial security of any organisation lending money, and risk management can, amongst other things, determine how a business's assets are allocated.
For example, above operational, liquidity or market risk, credit risk in banks and building societies is the biggest risk of all and they manage this vulnerability by diversification. In layman’s terms, this means banks avoid ‘putting all their eggs in one basket’ by spreading their money between a variety of assets, so if one investment goes belly up, a separate successful investment can compensate for the loss.
Credit agreement terms
Another way of managing risk is by a lender tailoring the terms of a credit or loan agreement according to how ‘risky’ a borrower is. A borrower’s risk rating will determine:
- the amount of credit they’re offered
- the interest rate applied
- the repayment terms of their loan or credit agreement
If a borrower is deemed to be a credit risk and is, therefore, more likely to default on their loan repayments, if they are offered a loan, the interest rate will be higher to safeguard the lender’s capital and income - or, the applicant may be rejected for credit altogether.
Conversely, someone with a strong financial background and respectable credit rating will typically be offered a much cheaper loan with a lower interest rate.
Finally, another measure companies can take to guard against credit risk is by taking out a specialist trade credit insurance policy.
Credit insurance provides protection for lenders in the event that customers stop paying or are late paying back the sum they have borrowed.
Trade credit insurance covers services and products that are repayable within one year.
In addition to providing insurance, insurers will also provide businesses with guidance and advice on credit risk management strategies and introduce policyholders to new markets to help their businesses flourish.
Credit insurance can be taken out for a whole portfolio of customers or applied to single accounts.
So, if you find yourself struggling to get credit and your applications are being declined, it’s most likely lenders see you as a credit risk as you have a bad credit score and patchy credit history.
If you’ve been the victim of fraud, check out our other handy guide: How to fix your credit score about being scammed.
If you have a good credit score but can’t get credit, find out why by reading Excellent credit score, but refused credit?
And if you're not sure what your credit rating is currently looking like, sign up to Checkmyfile today (30-day free trial but easy cancellation):