Lenders, bankers, cryptocurrency firms and more understand the importance of “credit risk” and its applicability to their operations.
Let’s find out more about credit risk and how it affects financial institutions and individuals.
The Definition of Credit Risk
For a lender, credit risk refers to the possibility of a loss of funds within a loan transaction. The credit may come in terms of a loan or a credit card or other debt instruments. The conditions of the credit may also be different. The risk of credit not being returned to the lender is always present.
Since the lender loses the funds they provided to the borrower, credit risk is one of the most pressing and important aspects within any similar transaction.
What are the Types of Credit Risk?
Credit risk is not a problem that may be solved, but a risk that must be dealt with to mitigate the effects of a possible loss. As such, financial institutions input processes in place to minimize risk.
There are three types of credit risks that may be largely seen in a financial environment.
- Credit Default Risk. This applies to situations where an individual debtor is not able to return the payment within 90 days of the contractual agreement.
- Concentration Risk. This takes place when the lender faces a collective loss that may adversely affect their operations (e.g., Lehman Brothers or Bear Stearns). This is associated largely with a single group of similar debtors. In some cases, it may be a debt lent out to a single entity that is large enough to have this effect (e.g., Iron Throne and Iron Bank).
- Country Risk. This is by far the largest and most impactful risk of all. This happens when a sovereign country defaults on its own financial obligations or stops its foreign currency transactions. While rare, the risk is a significant problem for financial institutions.
Varied Forms of Credit Risk
Credit risk could also take place in settings that are not traditionally financial. For instance, when an employee works for an organization and hopes to get remunerated at the end of a period, they are dealing with credit risk.
Credit risk is also present within the cryptocurrency world regarding exchanges, wallets, and other entities involved with managing or holding user funds.
Individuals may expect their digital assets to be safe within a wallet when it isn’t.
Credit risk in cryptocurrency is a bit more complex and deals with the credibility of the firm, the cyber risk, and other factors that deal with the protection and safeguarding of digital assets.
How is Credit Risk Managed?
Lenders and institutions must make sure that they have proper credit risk management in place.
To mitigate consumer credit risk, some lenders go with the option of credit scoring (which is very popular for individual debtors). Other options apply in mechanisms including but not limited to credit insurance, derivatives, and deposit insurance.
The consumer may minimize their risk of loss by dealing with institutions and individuals that are credible, have methods to insure against losses, and have a history of strong security protocols to safeguard assets.