Credit Risk is the risk of capital loss, caused by the default of a debt. Every credit operation has an associated default risk.
A borrower may not fulfill an agreement by the following ways:
- partial payment.
- payment dates other than those prearranged.
The interest rate represents the cost of the use of money over time, plus a compensation for the credit risk.
Every borrower has a different estimated risk. It’s considered that Short Time US Treasury Bills are among the lowest risk investments. It’s interest rate is very low, because it’s credit risk is very low. The real interest rate (taking into account the inflation rate).
There are several types of risk:
- Liquidity risk: lack of funds by the borrower.
- Instrumentation risk: lack of full knowledge about legal agreements, contracts and legal rules.
- Solvency risk: absence of guarantees or collateral assets.
For the lender, it’s a problem of imperfect information. The lender doesn’t know the probability of default. He cannot fully know the financial situation of the borrower, his business and the future prospects of the business, the economy sector in which it’s operates and the economy.
Credit institutions, such as banks, employ their own model to classify its clients. A credit scorecard is the outcome of such models.
Given that the search of information is costly, there are companies engaged in evaluate the financial situation of big companies and governments. This companies are called “Credit Rating Agencies”. Some of the biggest credit rating agencies are Standard & Poor’s, Fitch Ratings and Moody’s. The credibility of these companies has fallen after the subprime financial crisis. Rating agencies gave highest ratings to mortgage-backed securities, whose value fell a lot right after the crisis. Lehman Brothers has a very high rating on the day of it’s bankruptcy.
Credit companies should have a policy of risk diversification, avoiding high exposure to an economy sector (technology, construction, industry, etc.) or to a category of clients (individuals, small companies, big companies, government).