It may be problematic to know if a lender cannot meet contractual requirements because of loan, even after a thorough evaluation. Meanwhile, handling credit risk can reduce the rigorousness of the loss. The compensation for the lenders taking on these hazards is gained from the interest charged on the loan.
What is credit risk?
Credit risk simply refers to probable loss because of a borrower’s inability to repay the loan or meet his/her contractual responsibilities. In other words, it is a risk that the lender bears on the potential of not receiving the owed principal and interest. This could bring about an interruption of cash flows and higher costs of collection.
Types of credit risk
Essentially, there are three kinds of credit risk, and they include:
- Default Risk: This occurs because of the inability of the borrower to pay back the loan amount when due.
The risk due to the reduction in the hazard of the rating lender.
Credit spread risk: This arises from the irregularity in the difference between interest rates in investment and the risk-free return rate.
Credit risk management
After the economic recession of 2008, a lot of companies realized there is no such thing as a ‘large company’ if the organisation cannot make enough provision for risk evaluation. Even if your business is on a good standing, you may be associated with some unsafe businesses and their collapse could lead to yours.
Because of this, business have to stick to strict laws and sensitive necessities for accountability and risk management. Risk management is simply a strategic measure taken for business sustainability.
Benefits of risk management
- Lets you to identify future clients that may come at too high risk and beyond the level of risk you can take,
- Can be taken advantage of as a strategic chance,
- Brings about improvement in the all-round performance of the business and gives it a competitive edge.
How to migrate to credit risk
- Evaluate the credit history of possible customers thoroughly, beginning with credit scores which shows the type of risk your possible client is carrying.
- Build a customer relationship based on long term.
- Ensure your agreement with the customer is very clear.
- Set a credit limit for possible clients.
- Develop a stand policy to handle overdue payments.
- Go for credit insurance to your advantage.