The very nature of businesses makes them hazardous. It is the single thing that unites them despite being in different fields and on different continents. Even though there will always be risks associated with running a business, those risks may be mitigated.
Exposure To The Risk Of Credit
One must first have an understanding of credit risk before being able to appreciate credit risk exposure. It is the possibility that a borrower may not repay the amount that is owed, resulting in a disruption of the lender’s cash flow as well as higher expenses associated with collection efforts. The following are some examples of credit risks:
- A borrower who is behind on the payment of interest, principle, or both on a credit card or mortgage debt.
- A creditor who is unable to pay the trade invoice that was issued to them
- A business that has not paid its employees their earned wages or salaries promptly
- One of the aspects of credit risk is that of exposure to credit risk. If a borrower defaults on their loan, the lender stands to lose the most money possible. Additional factors that contribute to credit risk are as follows:
- The default probability is an assessment of the possibility that the borrower will fail to fulfill his obligations as outlined in the contract.
- Recovery rate: the percentage of delinquent loans that have a chance of being recouped by various means, such as debt collection or recovery procedures
Various Categorizations Of Credit Risk
Credit risk may be broken down into three categories, which are as follows:
1. The Possibility Of A Credit Default
This occurs when the borrower fails to fulfill the requirements associated with the loan and the due date has passed after ninety days have elapsed.
2. Concentration Hazard
When the risk of the lender is tied to a single exposure or combination of exposures that can impair the core operations of the company. This often arises when portfolios are not properly diversified or when businesses rely on a single partner for a significant portion of their income. Additionally, it can develop when an organization has a high concentration of its assets in a single location.
3. Risk Posed By The Nation
The risk that a nation may be unable to meet its commitments to make payments denominated in a foreign currency is referred to as “country risk.” The political stability and macroeconomic performance of a sovereign state are directly tied to a country’s level of exposure to country risk.
What Are The Benefits Of Being Exposed To Credit Risk?
Examination of the lender’s credit risk exposure can help the lender lower the amount of risk they are exposed to. If a borrower has no credit history or poor credit history, a lender could decide to tighten the criteria for the collateral needed to get a loan or issue the loan but charge a higher interest rate. A person who has a high credit score may be qualified for a loan from the same supplier that has a higher principal amount and a lower interest rate. In a similar vein, investors who have a low tolerance for risk would wish to avoid purchasing bonds that have received low ratings.
Credit default swaps are another option for lenders that want to limit their vulnerability to the credit risk that they take on. The seller is responsible for making interest payments to the buyer. If the borrower does not pay back the loan, the seller is responsible for paying back the premium to the buyer.