Credit Risk Analysis (2024)

The process to balance the estimated costs of credit risks against the benefits that achieve the lender’s business objectives

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Credit risk analysis extends beyond credit analysis and is the process that achieves a lender’s goals by weighing the costs and benefits of taking on credit risk.

By balancing the costs and benefits of granting credit, lenders measure, analyze and manage risks their business is willing to accept.

The creditworthiness of the borrower, derived from the credit analysis process, is not the only risk lenders face. When granting credit, lenders also consider potential losses from non-performance, such as missed payments and potential bad debt. With such risks come costs, so lenders weigh them against anticipated benefits such as risk-adjusted return on capital (RAROC).

Credit Risk Analysis (1)

Key Highlights

  • Credit risk analysis determines a borrower’s ability to meet their debt obligations and the lender’s aim when advancing credit.
  • Expected losses, risk-adjusted return, and other considerations all serve to inform the outcome of the credit risk analysis process.
  • Three factors to quantify the expected loss (cost of credit risk) include the probability of default, loss given default, and exposure at default.

Purpose of Credit Risk Analysis

Credit risk analysis aims to take on an acceptable level of risk to advance the lenders’ goals. Goals can include profitability, business growth, and qualitative factors. Management crafts policies that drive their business to achieve its goals.

Although credit analysis can rate risks and estimate the probability of default, default risk is only one entity-specific risk factor. Lenders consider costs and benefits holistically when determining if the anticipated outcomes are acceptable to their business and financial exposure.

To estimate the cost of risk, lenders employ a multitude of information from the borrower, the lender, and external parties such as credit agencies. Some measures, such as credit scores and credit risk analysis models, are tools that allow lenders to estimate their expected loss (EL) via the probability of default (PD), loss-given default (LGD), and exposure at default (EAD).

The direct benefit of taking on credit risk is interest, a combination of default risk premium, liquidity premium, and other factors; however, benefits extend beyond interest revenue. For example, lenders may take on additional credit risk to grow a credit portfolio (their asset base), gain market share and expand relationships, or ensure their portfolio achieves an acceptable risk-adjusted return on capital.

Individual outcomes of credit risk analysis include granting credit with specific credit conditions or even approving exceptional credit to borrowers who may not qualify within standard policies. Management’s goal is to mitigate the portfolio credit risks sufficiently to optimize the firm’s accepted risks in aggregate.

For example, credit risk analysis can determine that lending in the absence of financial risk (e.g., cash-secured lending) is still not acceptable, perhaps due to headline risk specific to the borrower’s owner or the industry that the company operates in.

Conversely, credit risk analysis may support lending to a newer business model (i.e., without proven cash flow) as a business strategy to expand relationships and increase exposure to a growing segment.

Credit problems and risk management

Credit risk management is a key issue that lenders of all forms must address. BIS[1] has identified three key areas: concentration, credit processes, and market and liquidity-sensitive exposures.

  • Concentration reflects not the largest borrowers per se but exposures where the expected loss can sizably deplete the capital. For example, in trade credit, if a lender offers the same terms (amount, repayment, etc.) to a business with no track record and a publicly traded company, the credit concentration is considered more significant with the former compared to the latter. If this exposure has an expected loss that will deplete the lender’s capital to an unacceptable level, that risk must be adjusted accordingly.
  • Credit processes encompass lenders’ steps to assess, measure, and conduct credit risk analyses. Errors in the process lead to credit problems for the lender, for example:
    • Leveraging value-at-risk (VaR) models with unvalidated tail risks and loss.
    • Decisions that are not easily replicable, resulting in inconsistent results and unmanaged portfolio risk.
    • Poor monitoring and control of collateral and fraud, leaving any losses higher than expected.
    • Consistent mispricing and assessment of non-financial collateral in light of market conditions or business cycles, resulting in poor risk-adjusted return and higher than planned concentration risk.
  • Market and liquidity-sensitive exposures include foreign exchange risks, financial derivatives, and contingent liabilities. There is a difference between willingness and ability to pay, particularly for illiquid collateral or volatility, causing an outsized increase in exposure compared to the collateral value. If the borrower cannot access sufficient liquidity, the risk to the lender will rise regardless of willingness to repay. Stress testing is one way to structure and manage credit risk.

Additional Resources

CFI offers the program for finance professionals looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant CFI resources below:

  • Credit Rating
  • Debt Covenants
  • Risk
  • See all commercial lending resources

Article Sources

  1. BIS
Credit Risk Analysis (2024)

FAQs

Credit Risk Analysis? ›

What is Credit Risk Analysis? Credit risk analysis is the means of assessing the probability that a customer will default on a payment before you extend trade credit. To determine the creditworthiness of a customer, you need to understand their reputation for paying on time and their capacity to continue to do so.

What are the 5 components of credit risk analysis? ›

The lender will typically follow what is called the Five Cs of Credit: Character, Capacity, Capital, Collateral and Conditions. Examining each of these things helps the lender determine the level of risk associated with providing the borrower with the requested funds.

How to analyze credit risk? ›

Lenders look at a variety of factors in attempting to quantify credit risk. Three common measures are probability of default, loss given default, and exposure at default. Probability of default measures the likelihood that a borrower will be unable to make payments in a timely manner.

What are the 5 Cs of credit analysis? ›

Credit analysis is governed by the “5 C's of credit:” character, capacity, condition, capital and collateral.

What does a credit risk analyst do? ›

Credit Risk Analysts analyze credit data and financial statements of individuals or firms to determine the degree of risk involved in extending credit or lending money. Prepare reports with credit information for use in decisionmaking.

What are the 5 Cs of risk assessment? ›

The 5 Cs of Credit analysis are - Character, Capacity, Capital, Collateral, and Conditions. They are used by lenders to evaluate a borrower's creditworthiness and include factors such as the borrower's reputation, income, assets, collateral, and the economic conditions impacting repayment.

What are the four 4 Cs of the credit analysis process? ›

The “4 Cs” of credit—capacity, collateral, covenants, and character—provide a useful framework for evaluating credit risk.

What is the 5c analysis of credit risk? ›

Lenders also use these five Cs—character, capacity, capital, collateral, and conditions—to set your loan rates and loan terms.

What is a key risk indicator for credit risk? ›

Credit Risk Indicators: Potential KRIs include high loan default rates, low credit quality, the percentage of high-risk loans in the portfolio, or high loan concentrations in specific sectors.

Which technique is used in credit risk analysis? ›

Credit risk modeling is a technique used by lenders to determine the level of credit risk associated with extending credit to a borrower. Credit risk analysis models can be based on either financial statement analysis, default probability, or machine learning.

What are the 7 P's of credit? ›

The 7 Ps are principles of productive purpose, personality, productivity, phased disbursement, proper utilization, payment, and protection, which guide banks to only lend for income-generating activities, consider borrower trustworthiness, maximize resource productivity, disburse loans gradually, ensure proper use of ...

How credit analysis is done? ›

In bank credit analysis, banks consider and evaluate every loan application based on merits. They check the creditworthiness of every individual or entity to determine the level of risk that they subject themself by lending to an entity or individual.

What are the 5 P's of lending? ›

Different models such as the 5C's of credit (Character, Capacity, Capital, Collateral and Conditions); the 5P's (Person, Payment, Principal, Purpose and Protection), the LAPP (Liquidity, Activity, Profitability and Potential), the CAMPARI (Character, Ability, Margin, Purpose, Amount, Repayment and Insurance) model and ...

What is the salary of credit risk analyst in JP Morgan? ›

Average JPMorgan Chase & Co. Credit Risk Analyst salary in India is ₹17.9 Lakhs per year for employees with less than 1 year of experience to 4 years. Credit Risk Analyst salary at JPMorgan Chase & Co. ranges between ₹8 Lakhs to ₹32 Lakhs per year.

Is credit risk analyst a stressful job? ›

Dealing with multiple projects with short deadlines can be a stressful event for most analysts, and they must find proper ways of managing work stress without stretching their limits or compromising the quality of work.

How much does a credit risk analyst make in the US? ›

The estimated total pay for a Credit Risk Analyst is $132,649 per year, with an average salary of $86,823 per year. These numbers represent the median, which is the midpoint of the ranges from our proprietary Total Pay Estimate model and based on salaries collected from our users.

What are the five main steps in risk analysis? ›

You can do it yourself or appoint a competent person to help you.
  • Identify hazards.
  • Assess the risks.
  • Control the risks.
  • Record your findings.
  • Review the controls.
Mar 28, 2024

What are the 5 components of risk? ›

The 5 Components of Risk Management Framework. There are at least five crucial components that must be considered when creating a risk management framework. They are risk identification; risk measurement and assessment; risk mitigation; risk reporting and monitoring; and risk governance.

What are the key elements of risk analysis? ›

Being prepared will always give your business the upper hand over your competitors — especially when something occurs that no one expects.
  • Identify Risks. ...
  • Evaluate and Rank The Potential of the Risks. ...
  • Develop Your Risk Document. ...
  • Determine the Controls for Risks. ...
  • Assign Risk Managers. ...
  • Review Your Risks.

References

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