What is credit risk? When does it occur?

When we decide on additional financial support in the form of a loan, the bank will always assess credit risk, i.e. any circumstances that may affect the disturbance in the normal course of repayment. There are many such impact factors, we will try to explain the majority in the material below.

Risk – what is that?

Risk - what is that?

To expand on the subject of credit risk, one must begin with a general concept of risk. Everything that you can find about risk in the professional literature comes down to describing it as an assessment of the risk that may result from probable events that are independent of us or from the consequences of making these and not other decisions. It is a bit complex, however, based on the example of credit risk, we will try to introduce this topic.

Credit risk and its types

Banks or non-banking institutions, when providing financial support to borrowers, take into account certain risks they incur. This means that the bank, by allowing us to make a commitment, bears the credit risk that we will not pay it back on time or at all. The bank will learn about the level of this risk by analyzing our financial situation and a number of documents that we will be required to provide in the application process. In addition, when assessing risk, the bank will also consider the currency in which you want to commit. So what are the types of credit risk that can have a very negative impact on the activity and activity of a particular bank:

  1. Active risk, also known as active risk – occurs when there are real financial losses arising from payments not made by borrowers
  2. Passive risk, called passive risk, associated with earlier withdrawal of deposited funds, i.e. earlier than specified in the contract.
  3. Individual risk individual – related to individual loan agreements
  4. Total risk, i.e. portfolio risk – this risk depends on many individual risks and has an impact on the entire loan portfolio in a given bank

It is also worth mentioning two types of risks, the name of which explains a lot – acceptable and unacceptable. In the first, the bank allows the risk of financial loss and in the second it is so high that it is unacceptable.

What factors affect the risk?

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When assessing credit risk, the bank analyzes many different factors that affect it. Among the basic is the type of borrower. Risk assessment and its result when analyzing a private individual will be different than in the case of a public sector entity. Another factor is the financial situation of the potential borrower.

And also an obvious factor, which is the amount of the loan that the borrower is applying for. Another factor that increases the level of credit risk is the purpose for which the loan is to be allocated. And this is also subject to reliable assessment. Currency, interest rate as well as the amount of own contribution that the future borrower will be obliged to make – this also significantly affects the risk.

What actions should you take to reduce your credit risk?

What actions should you take to reduce your credit risk?

If the level of credit risk is high, then the bank will be exposed to a loss of financial liquidity, it is significantly dangerous. To limit this, banks use various methods to prevent the bank’s worst bankruptcy. Among them may be, among others creation of bank reserves, or verification and then monitoring of borrowers.

This is to prevent any repayment difficulties, which the bank can react to earlier by proposing various solutions to clients. Proposing credit insurance is today one of the basic collateral for a bank loan if it turns out that the borrower cannot fulfill his obligation. And the least pleasant but effective way is any tightening of contractual provisions which are to protect the bank against any unreliable borrowers.

Can you control your credit risk?

Can you control your credit risk?

All that a bank can do is to scrupulously and quickly assess credit risk before granting a loan to the applicant. The analysis of customer credit history is of fundamental importance because it shows the customer as he is. This allows banks to control their risk to some extent, knowing all the customer’s behavior in dealing with previous loans. For this they use a tool such as credit scoring.

When applying for a loan, the bank gives itself as much time as it needs to analyze everything and issue a decision on granting or refusing a loan. If we don’t have time for this, we can use financing in non-banking institutions and companies that minimize formalities. And the decision-making process takes place much faster than in banks.

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