Credit Risk1

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Credit riskis an investor's risk of loss arising from

a borrower who does not make payments as

promised. Such an event is called a default.Another term for credit risk is default risk.

Credit risks are a vital component of

fixed-income investing.


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Investor losses include :

lost principal and interest,

decreased cash flow, andincreased collection costs,

which arise in a number of circumstances like :

1. A consumer does not make a paymentdue on a mortgage loan, credit card, line of

credit, or other loan.


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2. A business does not make a payment due on a

mortgage, credit card, line of credit, or other loan.

3. A business or consumer does not pay a trade

invoice when due.

4. A business does not pay an employee's

earned wages when due.

5. A business or government bond issuer does

not make a payment on a coupon or principal

payment when due.


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6. An insolvent insurance company does not pay a policy

obligation.

7. An insolvent bank won't return funds to a depositor.

8. A government grants bankruptcy protection

to an insolvent consumer or business.


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Thus, Credit riskis risk due to uncertainty in a

counterparty's (also called an obligor's or credit's)

ability to meet its obligations.

There are :

many types ofcounterpartiesfrom

individuals to sovereign governments,

many different types ofobligationsfrom

auto loans to derivatives transactions

Thus, credit risk takes many forms.


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In simple words, Credit Risk is defined as:

The risk that a borrower will be unable to make payment

of interest or principal in a timely manner.

Credit risk is the oldest risk among the various types of

risk in the financial system.

Growth in markets, disintermediation, and

the introduction of number of innovativeproducts & practices have changed the way

credit risk is measured & managed in todays

environment.


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Studies have carried out on bank failures in U.S show

that Credit Risk alone has accounted for 71% of large

bank failures in the period from 1980 to 2004.

Credit risk arises from many banking credit riskmanagement activities apart from traditional lending.

Credit riskcan be segmented into 2

major segments:

1. Intrinsic credit risk

2. Portfolio credit risk


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The focus ofintrinsic riskis the measurement of risk at

individual loan level. This is carried out at lending unit

level.

Portfolio riskarises as a result of concentration of portfolio

to a particular sector,

geographic area,

industry,type of facility,

type of borrowers,

similar rating, etc.


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Concentration riskis managed at bank level as it is more

relevant at that level.

Management of Credit Risk:

1. Cash Payment with order

2. Cash On Delivery

3. Open Account

4. Consignment Accounts

5. Bills of Exchange


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Increase in bankruptcies

Deregulation

Disintermediation Shrinking margins on loans

Growth of off-balance sheet risk

Volatility in the value of collateral

Advances in finance theory & computertechnology

Risk based capital regulations


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The effective credit risk management framework

comprises of distinctive building blocks:

a) Policy & strategyb) Organizational structure

c) Operations/systems.


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Approaches to credit risk measurement:

intrinsic risk

Expert Systems

Credit Ratings

Credit Scoring


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A credit risk model determines the present value of a given

loan or fixed income security, given our past experience and

assumptions about future.Credit risk models are intended to aid banks in quantifying,

aggregating & managing risk across geographical & product

lines.

It may result in better internal riskmanagement


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Creditrisk

models

Z-scoremodel

KMVmodel

CreditMetrices

Creditrisk+

model

4 models are available for measuring credit

risk:


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Principles of assessment of banks management of credit

risk:Establishing an appropriate credit risk

environmentOperating under a sound credit granting process

Maintaining an appropriate credit

administration, measurement & monitoring

process.Ensuring adequate controls over credit risk

The role f supervisors.


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There are many risks involved in exporting. They are:

Credit risk

Poor quality riskTransportation and logistics risks

Legal risks

Political risks

Unforeseen risksExchange rate risks

Cultural and language risks

Companies need to develop a professional approach when

entering the field of exporting.


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Companies will also face greater competition and more

stringent rules and regulations pertaining to products and

packaging.

Poor quality risk:

If the goods to be exported are not inspected

before they are shipped by an independent

third-party, the exporter may find his entireshipment being rejected on arrival at the

importer's premises due to the poor quality of

the goods.


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Credit risk in exporting:

In most instances - mainly because of the large

distances and alien environments involved - it is

generally difficult for the exporter to verify the

creditworthiness and reputation of an importer. If thecreditworthiness of a foreign buyer is unknown there is

the increased risk of non-payment,

late payment or even

straightforward fraud.


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It is essential, therefore, that the exporter should strive to

determine the creditworthiness of the foreign buyer.

Transportation and logistic risks:

With the movement of goods from one

continent to another, or even within the

same continent, goods face many hazards.

There is the risk of theft, damage and

possibly the goods not even arriving at all.


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Legal risks

International laws and regulations change frequently

and/or may be applied differently from that of theexporter's own country.

Political risk

The political stability of a foreign country

into which a company is exporting is of the

utmost importance.


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Unforseen risks

A natural disaster or terrorist action in a particular country

could completely destroy an export market for a company. Culture and language risk

Misunderstandings in communication and

in international trade transactions arisebecause in most instances the importer and

exporter come from different cultures and

express themselves with different languages.


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Exchange Rate risk:

The risk that a business' operations or an

investment's value will be affected by changesin exchange rates.

This risk usually affects

businesses, but it can also affect

individual investors who make

international investments. also

called currency risk.


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Managing Exporting Risks

The task of managing export-related risks begins with

knowing the kind of risk.

Steps in managing risk:

identify the risks

'weighting' the seriousness of the risk.

obtain insurance to cover the risk


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Three main types of risk cover include

credit risk cover,

country risk cover and transit risk cover


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