Anyone working in the financial sector can understand that banking operations often come with a risk factor associated with strategy, compliance, cyber security, liquidity, market, credit, and operations. Out of these, credit risk is one of the most critical types of risks commercial banks face. It is a kind of risk that banks take when they lend money to borrowers. They may default or fail to pay their dues in time, leading to a loss to the bank. So, what can banks do? They may hire a credit research and analytics company to conduct research, analyse, and manage their credit risk.
The goal of research in the credit field is to maintain a proper balance between risk exposure and acceptable parameters. It may help mitigate the losses by understanding a bank’s loan loss reserves and capital. For this, banks need to manage portfolio for their individual credits. Let us see how credit research helps in credit risk management.
Types of Credit Risk in Banks
Each time a bank or financial institution lends money, certain risk elements are involved. It refers to the possibility of loss due to a borrower defaulting. Applicable to both the interest and the principal, it may result in interrupted cash flows. It also increases the bank’s expenses on the collections department. Since it is challenging for the banks to identify the borrowers at risk, they must use credit research metrics to manage credit risk. Different types of credit risks involved in the banking sector include:
Default: This risk can occur when a borrower fails to make contractual payments.
Credit Spread: This risk is caused due to the changeability between the risk-free return and interest rates.
Downgrade: A downgrade risk happens when a credit bureau reduces its rating on a bond.
Concentration Risk: When excessive exposure is given to a particular industry, investor, or financial institution, it can lead to concentration risk.
Institutional Risk: An institution may encounter this risk when its legal structure breaks down. It may also happen when the entity overseeing the agreement between the debtor and the lender has an issue.
What Does Credit Research Involve?
Tap directly into a credit research analyst and gain a detailed insight into varied credit-related topics. The service includes detailed and extensive coverage on the creditworthiness of financial institutions, consumers, private and public firms, project finance, commercial real estate, financial instruments, and sovereigns. Research in these fields enables you to assess and manage risks associated with credit, investment, and origination.
Forward-looking, up-to-date research results give you quantitative insight into the credit industry. It helps you to stay informed about the evolving credit issues. With well-structured financials, forecasts, statistics, and ratios, you can gain data-based results that you can use to make your credit-related decisions. Timely research can also spotlight the latest trends in the credit field. The studies of default and recovery give an insight into how economic cycles affect the loss rates in different regions and sectors.
With proper research and study, you may predict a borrower’s probability of default. It also helps calculate the total amount the lender or the bank expects to collect over the loan term. You may also calculate the recovery rate, which is the proportion of the total amount that the lender may accumulate in the event of a default.
Steps to Calculate Credit Risk
Credit research helps predict who can default on loans, depending on which banks can decide the credit amount and interest rate. These are the steps to calculate the credit risk of a borrower:
- Check the borrower’s credit score: Checking the credit score helps determine the borrower’s creditworthiness, based on which the lender can identity the potential risk involved.
- Calculate the DTI Ratio: Calculating the borrower’s debt-to-income ratio helps a lender determine an individual’s financial status and repayment capacity. DTI ratio indicates whether a borrower has sufficient cash flow to repay the borrowed amount. Ideally, a borrower’s DTI ratio should not exceed 35%. Credit research also helps determine an individual’s borrowing pattern.
- Evaluate Credit Utilisation Ratio: An individual with a high credit utilisation ratio is often perceived as a high-risk credit-hungry borrower. Financial institutions must consider borrowers’ credit utilization ratios while determining their credit risk.
An ideal way to manage credit risk is to use credit research and analysis results. Besides improving credit risk management for financial institutions, research results can also provide analytics and possible solutions to drive lending growth. Implementing research in the field can help creditors lend more credit with minimal risk involved.
Credit Research is a practical step in identifying a financial institution’s overall risk by viewing it at the consumer, individual, and portfolio levels. Without thorough research, banks cannot identify the risks involved and suffer debilitating losses. Therefore, the key to reducing credit loss is to ensure appropriate implementation with valuable research results. Get in touch with a knowledge partner to gain insight with proper research and analytics provided by experts.
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