What is credit risk? What are the causes and consequences

What is credit risk? The causes and consequences of credit risk are often overlooked. Instead, people are only interested in the concept of bank credit. However, if you do not fully understand these terms, the consequences will be extremely serious when taking out a loan.

So to answer these questions, please follow the information provided by Fastloans.PH in the following article.

What is credit risk?

Credit risk is the risk when a borrower fails to comply with the terms of the credit contract, the most common of which is the failure to recover the loan amount due to the customer’s inability to pay.

You can understand this as a situation of financial loss when there is a problem in the transaction. When credit risk occurs, you will not be able to pay the principal and interest on time to the bank. At this time, the bank will suffer serious losses. If this situation persists for a long time, it will also affect the overall economy of the country.

what-is-credit-risk

Credit risk is not limited to installment loans. This situation occurs in many other credit activities of the bank. Specifically like:

  • Guarantee
  • Commit
  • Trade finance approval
  • Stock market.

Credit risk classification

Credit risk includes portfolio risk and transaction risk, in which portfolio risk is divided into two types of intrinsic risk and concentration risk.

Intrinsic risk comes from factors that are unique to each borrower or economic sector.

Concentration risk is the accumulation of outstanding loans to a few customers, several economic sectors, or several types of loans, or to a single geographical area.

Transaction risk has three components: selection risk, security risk, and operational risk.

  • Selection risk is the risk associated with credit appraisal and analysis.
  • Assurance risk comes from assurance standards.
  • Operational risk is the risk related to the management of lending activities.

What are the causes of credit risk?

Credit risk occurs due to many different reasons. In which the main cause mainly comes from the following cases.

Credit risk due to environmental impact

The bank is one of the organizations operating on a large scale, so it is also strongly influenced by external factors. In which credit risk is greatly affected by the economic, political, cultural, and social environment, etc. So when the country’s economy is stable, financial risks rarely occur.

Credit risk due to the bank

External financial risk is affected by the external environment, the influence from the bank itself is higher. The bank will give loans to those who are able to afford loans by considering the number of assets, main and secondary sources of income, etc.

However, by the time of repayment of principal and interest, the borrower could not afford to pay. Therefore, the bank has to adjust the credit risk provision plan. However, it still affects the capital turnover process of the bank. This makes the probability of credit risk high.

Credit risk due to customers

The purpose of unsecured loans, mortgage loans of each person is different and how the borrower uses the loan amount, the bank cannot control.

Therefore, when someone deliberately scams does not pay the bank on time, it will cause problems with the system. Thus, the lending institution will not be able to manage credit risk, so this is also the cause of this risk situation.

The cause of credit risk due to customers can come from individual and corporate customers.

For individual customers:

  • Due to health situation, illness
  • Job loss, unemployment
  • Family conflict
  • Moral hazard

For corporate customers:

  • The ability to manage the business is not good and weak.
  • Corruption in the internal structure of enterprises.
  • Inefficient use of capital.

See also: What is debit note? 7 basic information about debit note

What are the consequences of credit risk?

When a credit risk situation occurs, the consequences of leaving are extremely serious. It affects not only the individual borrower but the bank and the economy as a whole.

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Impact of credit risk on the bank’s operations

Particularly for banks, credit risk makes this organization lose the opportunity to receive interest. In addition, it also causes loss to the bank’s profits and capital. If the situation becomes serious, the bank will be insolvent leading to bankruptcy.

The bad debt situation of a bank due to the inability to recover loans leads to the supervision of the State Bank, thereby its reputation is reduced and the operating range is also affected, which is also a consequence of the risk. credit risk.

Impact of credit risk on the economy

It also stems from the fact that the bank has a high rate of bad debt, leading to a reputational damage that causes loss of trust in customers. From there, customers who have savings at this bank will come to withdraw money, causing some serious consequences such as:

Banks running out of capital are forced to borrow from other banks or from state banks
The currency balance is disturbed, leading to an unstable economy

Criteria for assessing credit risk in the bank

In the banking sector, credit risk is assessed based on criteria such as overdue debt, bad debt and credit risk provision.

Overdue

This is the basic indicator to reflect credit risk. Overdue debt is a debt that will arise when it is time to pay the debt as committed in the contract but the borrower is unable to repay part or all of the loan to the lender and is divided into debt groups. bad.

Overdue debt is reflected through the following two criteria:

Past due ratio = Overdue balance/Total outstanding balance

Percentage of customers with overdue debt = Number of customers with overdue debt / Total number of customers with outstanding balance

If a bank has a target of overdue debt and a large number of customers with overdue debts, that bank is at high risk and vice versa.

Bad debt

By definition, bad debts are debts that are overdue for more than 90 days and are doubtful about their ability to repay and their ability to recover capital. The bad debt ratio will clearly reflect the credit quality of the bank. If a bank has a high NPL ratio, it shows that this bank is not doing well in risk management and input customer evaluation.

Indicators reflecting bad debt include:

Bad debt ratio = Bad debt/Total outstanding balance. According to the World Bank, this ratio below 5% is acceptable and preferably at 1-3%
Proportion of bad debt by debt group = Bad debt balance of group (3,4,5)/Total bad debt balance
Bad debt to equity ratio = Bad debt/Equity
Ratio of bad debt to loss provision fund = Bad debt/loss provision fund

Provision for credit risk

Provision for risks is an amount set aside and accounted into operating expenses to make provision for possible losses to debts of credit institutions, foreign bank branches. Provisions for credit risk are calculated on the principal balance of customers, including:

Specific provisions – to cover specific risks for each loan
General provision – insurance for unspecified general risks in the credit portfolio and the entire provision is charged to the operating expenses of the business.

Credit risk management and handling process

The credit risk management and handling process includes 4 steps:

Step 1. Calculation to determine risk

Step 2. Quantify the risk

Step 3. Management and supervision

Step 4. Provide methods for dealing with risks

Conclusion

What is credit risk? What are the causes and consequences of this problem? All have been shared very specifically in the above article.

Hopefully, through this information, you will gain insight into the consequences of credit risk. In addition, you can visit the website: https://Fastloans.PH/ to learn more.

See also: What is ROA, ROE? How to analyze finance by ROA and ROE

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