Credit worthiness

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Credit worthiness is another way to say "credit risk".

Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both).

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Faced by lenders to consumers

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Most lenders employ their own models (credit scorecards) to rank potential and existing customers according to risk, and then apply appropriate strategies. With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa. With revolving products such as credit cards and overdrafts, risk is controlled through the setting of credit limits. Some products also require security, most commonly in the form of property.

Faced by lenders to business

Lenders will trade off the cost/benefits of a loan according to its risks and the interest charged. But interest rates are not the only method to compensate for risk. Protective covenants are written into loan agreements that allow the lender some controls. These covenants may:

  • limit the borrower's ability to weaken their balance sheet voluntarily e.g., by buying back shares, or paying dividends, or borrowing further.
  • allow for monitoring the debt requiring audits, and monthly reports
  • allow the lender to decide when he can recall the loan based on specific events or when financial ratios like debt/equity, or interest coverage deteriorate.

A recent innovation to protect lenders and bond holders from the danger of default are credit derivatives, most commonly in the form of a credit default swap. These financial contracts allow companies to buy protection against defaults, from a third party, the protection seller. The protection seller receives a periodic fee (the credit spread) as compensation for the risk it takes, and in return it agrees to buy the debt should a credit event ("default") occur.

Credit scoring models also form part of the framework used by banks or lending institutions grant credit to clients. For corporate and commercial borrowers, these models generally have qualitative and quantitative sections outlining various aspects of the risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively. Once this information has been fully reviewed by credit officers and credit committees, the lender provides the funds subject to the terms and conditions presented within the contact (as outlined above).

Faced by business

Companies carry credit risk when, for example, they do not demand up-front cash payment for products or services.[1] By delivering the product or service first and billing the customer later - if it's a business customer the terms may be quoted as net 30 - the company is carrying a risk between the delivery and payment.

Significant resources and sophisticated programs are used to analyze and manage risk. Some companies run a credit risk department whose job is to assess the financial health of their customers, and extend credit (or not) accordingly. They may use in house programs to advise on avoiding, reducing and transferring risk. They also use third party provided intelligence. Companies like Standard & Poor's, Moody's, Fitch Ratings, and Dun and Bradstreet provide such information for a fee.

For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by tightening payment terms to "net 15", or by actually selling fewer products on credit to the retailer, or even cutting off credit entirely, and demanding payment in advance. Such strategies impact sales volume but reduce exposure to credit risk and subsequent payment defaults.

Credit risk is not really manageable for very small companies (i.e., those with only one or two customers). This makes these companies very vulnerable to defaults, or even payment delays by their customers.

The use of a collection agency is not really a tool to manage credit risk; rather, it is an extreme measure closer to a write down in that the creditor expects a below-agreed return after the collection agency takes its share (if it is able to get anything at all).

Faced by individuals

Consumers may face credit risk in a direct form as depositors at banks or as investors/lenders. They may also face credit risk when entering into standard commercial transactions by providing a deposit to their counterparty, e.g., for a large purchase or a real estate rental. Employees of any firm also depend on the firm's ability to pay wages, and are exposed to the credit risk of their employer.

In some cases, governments recognize that an individual's capacity to evaluate credit risk may be limited, and the risk may reduce economic efficiency; governments may enact various legal measures or mechanisms with the intention of protecting consumers against some of these risks. Bank deposits, notably, are insured in many countries (to some maximum amount) for individuals, effectively limiting their credit risk to banks and increasing their willingness to use the banking system.

Counterparty risk

Counterparty risk, otherwise known as default risk, is the risk that an organization does not pay out on a credit derivative, credit default swap, credit insurance contract, or other trade or transaction when it is supposed to.[2] Even organizations who think that they have hedged their bets by buying credit insurance of some sort still face the risk that the insurer will be unable to pay, either due to temporary liquidity issues or longer term systemic issues.[3]

Large insurers are counterparties to many transactions, and thus this is the kind of risk that prompts financial regulators to act, e.g., the bailout of insurer AIG.

On the methodological side, counterparty risk can be affected by wrong way risk, namely the risk that different risk factors be correlated in the most harmful direction. Including correlation between the portfolio risk factors and the counterparty default into the methodology is not trivial, see for example Brigo and Pallavicini[4]

Sovereign risk

Sovereign risk is the risk of a government becoming unwilling or unable to meet its loan obligations, or reneging on loans it guarantees.[5] The existence of sovereign risk means that creditors should take a two-stage decision process when deciding to lend to a firm based in a foreign country. Firstly one should consider the sovereign risk quality of the country and then consider the firm's credit quality.[6]

Five macroeconomic variables that affect the probability of sovereign debt rescheduling are: [7]

  • Debt service ratio
  • Import ratio
  • Investment ratio
  • Variance of export revenue
  • Domestic money supply growth

The probability of rescheduling is an increasing function of debt service ratio, import ratio, variance of export revenue and domestic money supply growth. Frenkel, Karmann and Scholtens also argue that the likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity gains. Saunders argues that rescheduling can become more likely if the investment ratio rises as the foreign country could become less dependent on its external creditors and so be less concerned about receiving credit from these countries/investors. ( Cornett, Marcia Millon and Saunders, Anthony, Financial Institutions Management: A Risk Management Approach 5th Edition, 2006, McGraw Hill, ISBN 978-0073046679.

References

  • Bluhm, Christian, Ludger Overbeck, and Christoph Wagner, An Introduction to Credit Risk Modeling, 2002, publisher Chapman & Hall/CRC isbn 978-1584883265
  • Damiano Brigo and Massimo Masetti, Risk Neutral Pricing of Counterparty Risk, in Pykhtin, M. (Editor), Counterparty Credit Risk Modeling: Risk Management, Pricing and Regulation, 2006 publisher Risk Books, 1-904339-76-X
  • de Servigny, Arnaud and Olivier Renault, The Standard & Poor's Guide to Measuring and Managing Credit Risk, 2004, McGraw-Hill, isbn 978-0071417556
  • Darrell Duffie and Kenneth J. Singleton, Credit Risk: Pricing, Measurement, and Management, 2003, Princeton University Press, isbn 978-0691090467

See also

Other types of risk

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