What is credit risk?
Credit risk is the risk that a borrower will not be able to repay a loan. It is one of the most important risks faced by lenders, and it can have a significant impact on their profitability.
What are the factors that affect credit risk?
There are many factors that can affect credit risk, but some of the most important include:
- Borrower’s capacity to repay: This is the borrower’s ability to generate enough income to make the loan payments. It is important to consider the borrower’s income, expenses, and debt obligations when assessing their capacity to repay.
- Borrower’s collateral: Collateral is property that the borrower pledges to the lender in case they default on the loan. If the borrower defaults, the lender can sell the collateral to recover their losses.
- Borrower’s credit history: A borrower’s credit history is a record of their past borrowing and repayment behavior. It is important to review a borrower’s credit history to assess their risk of default.
- Economic conditions: Economic conditions can have a significant impact on credit risk. For example, a recession can lead to an increase in unemployment, which can make it more difficult for borrowers to repay their loans.
- Industry risk: The industry that a borrower operates in can also affect their credit risk. For example, borrowers in cyclical industries, such as construction, are more likely to default during economic downturns.
Multiple choice questions
- Which of the following is NOT a factor that affects credit risk?
- Borrower’s capacity to repay
- Borrower’s collateral
- Borrower’s credit history
- Lender’s interest rate
- Economic conditions
- The correct answer is “Lender’s interest rate.” The interest rate is a factor that affects the profitability of a loan, but it does not directly affect the borrower’s risk of default.
- A borrower has a credit score of 650. What is their risk of default?
- High
- Medium
- Low
- It cannot be determined from the information given.
- The correct answer is “It cannot be determined from the information given.” A credit score is a good indicator of a borrower’s credit risk, but it is not the only factor. Other factors, such as the borrower’s income, expenses, and debt obligations, also need to be considered.
- A borrower has a collateralized loan for $100,000. The value of the collateral is $150,000. What is the lender’s maximum loss if the borrower defaults?
- $0
- $50,000
- $100,000
- $150,000
- The correct answer is “$50,000.” The lender’s maximum loss is the amount of the loan that is not covered by the collateral. In this case, the lender’s maximum loss is $50,000.
Conclusion
Credit risk is a complex issue, and there is no single factor that can accurately predict a borrower’s risk of default. However, by carefully considering the factors listed above, lenders can make informed decisions about whether or not to extend credit to a borrower.