Credit Risk - Research Paper Example

The following part of this paper will make one aware of the concept of credit risk in detail. Credit risk-background The last few decades witnessed the collapse of some major banks as a result of borrowers’ credit repayment failure. Hence, many of the world’s largest banks and other financial institutions have developed comprehensive systems in order to deal with credit risk arising from different aspects of their businesses. The main objectives of such systems involve the identification, quantification, aggregation, and management of credit risk exposures.

In modern days, those systems constitute a major part of risk management and performance measurement. Circumstances of credit risk Credit risk issues mainly include lost principal and interest, diminishing cash flow, and rise in collection costs. The credit risk arises in a number of situations and some of them are described below. A business or consumer fails to pay the amount due on a mortgage loan, credit card, or other loan. A business or consumer makes no payment due on a trade invoice. A business fails to pay a worker’s earned wages when due.

A government bond issuer does not pay the amount due on a coupon or principal payment. An insolvent insurance company does not make a payment due on a policy obligation. A government sanctions bankruptcy permission to an insolvent business. Types of credit risk The credit risk is mainly of three types including default risk, credit spread risk, and downgrade risk. Default risk: When companies or individuals are unable to make payment due on their debt obligations, it is called default risk. Lenders and investors are vulnerable to default risk in all forms of credit extensions.

In order to mitigate the issues associated with the default risk, lenders often charge return rates that equals the debtor’s level of default risk. Credit spread risk: According to Fabozzi, when an issuer’s obligation performs inefficiently relative to other bonds as a result of an increase in the credit spread, it is called credit spread risk (638). When the credit spread increases, it leads to a proportional decline in the market price of the bond issue. Downgrade risk: as Fabozzi points out, an unexpected downgrading of an issue results in an increase in the credit spread and it subsequently leads to a decline in the price of the issue (638).

Such a risk is known as downgrade risk; it is very closely related to credit spread risk. Assessment of credit risk Nowadays, a variety of improved sources and sophisticated programs are applied to evaluate and manage credit risk. Some companies have established separate credit risk departments to examine the financial potency of their customers and sanction (or not) credit accordingly. Such departments conduct in house programs to effectively deal with the avoidance, reduction, and transfer of credit risk.

Standard & Poor’s, Fitch Ratings, and Dun and Bradstreet are some of the examples of organizations providing credit risk management services for a fixed fee. Majority lenders use their own models to determine and class existing as well as potential customers on the basis of risk and thereby to apply most suitable strategies. In case of products like unsecured personal loans and mortgages, lenders usually charge relatively higher price for higher risk clients in order to secure the transaction to some extent. In