Credit Risk Measurement

Knowledge of loan and associated financial risks is a necessary requirement for decision-makers of financial firms to make appropriate risk management decisions.

There is a need for decision-makers of companies that provide any form of financing to be knowledgeable about managing loan and associated financial risk. This way, they would be able to limit risk effectively at the lowest possible levels.

Financial risk refers to all risks that are associated with different forms of financing. The concept of risk hinges on the possibility of a negative impact from a future event that may diminish the current value of an asset. The level of financial risk is not the same for all investments. Rather, the former is largely dependent on the nature of the investment. Generally, investments that promise greater rewards are those that entail higher financial risks. The dilemma for investors of these financial products is to strike a balance between the probability of gaining a profit and the probability of not losing money.

There are four common risk categories that most financial firms face namely; market risk, funding or liquidity risk, credit risk, and operational risk. Market risk includes the probability of incurring losses from negative developments in the prices of certain financial assets, including interest rates and stock prices. To manage market risk, financial firms usually use hypothetical market movement scenarios to determine how their current portfolio values will be affected.

Funding or liquidity risk, on the other hand, is the risk that a firm or an individual may not be able to acquire the necessary funds to fulfill certain financial obligations of loan commitments. To manage this type of financial risk, firms usually establish contingency solutions, like backup lines of credit or holding sufficient liquid assets. Credit risk, meanwhile, refers to the risk that the firm’s borrowers may not be able to pay their debt obligations as soon as they become due. The most common way of managing this type of risk is the establishment of credit limits for all borrowers after a careful analysis of their capacity to pay. Many firms also use various quantitative models to measure and monitor credit risks. Lastly, operational risk refers to the risk of money loss as a result of failed or inefficient internal processes and systems or of an external event. To remedy this, appropriate operational risk management decisions would have to be made.

For financial firms, it is imperative to decide which risks to bear and to what degree or level these risks should be maintained. At the same time, these firms should be wary about putting their firms in unprofitable risk positions. Generally, financial firms set aside certain funds so they can cover their losses. These funds are usually categorized as capital and provisions. As capital, these funds can be reflected in many forms on financial statements and balance sheets. However, these are usually reflected as shareholder equity. Generally, these funds are used to cover extraordinary or unexpected losses. Provisions, on the other hand, are funds that are intentionally set aside to cover average or expected losses. Nevertheless, education about loan and associated financial risk is necessary to be able to make appropriate risk management decisions.