Evaluation of Credit Risk

Evaluating credit risk is one of the most important functions of financial institutions. The level of risk involved in a particular credit arrangement must be considered carefully before deciding whether to go ahead with a loan and what level of interest should be applied to that loan. While credit risk is generally seen as a negative, if managed properly, it can generate substantial profits for an organization, because riskier loans typically carry higher interest rates.

Risk-Free Lending

Literally speaking, there is no such thing as a risk-free loan. However, the concept is useful for developing an understanding of credit risk. A risk-free loan is guaranteed to be repaid to the lender at the agreed-on date. The interest on a risk-free loan, therefore, has no calculation for the potential risk of default. The interest rate is determined by perceived future interest rates and the time value of money, both of which generally ensure that a dollar today is worth more than a dollar tomorrow.

Possibility of Default

In the real world, there is always a chance that a borrower will default on his loan. The United States Treasury has often been used as an example of the closest real world example of a risk-free borrower; however, it is possible that even the American government could fail to repay holders of U.S. Treasury bonds. When the possibility of default is introduced into a lending model, that possibility must be factored into interest rate calculations. The risk of a default has a monetary value and those who take on risk must be compensated. For example, if the issuer of a class of $1,000 debt instruments has a 10 percent chance of defaulting on those bonds, the value of that risk can roughly be said to be $100 per bond, which is equal to the probability of default times the size of the default: 10 percent of $1,000 = $100. This is known as the risk premium.

Endogenous Models

Two major models determine the risk of default. Endogenous models look at factors inherent to the borrower. For example, a borrower's credit history might show late payments or previous bankruptcy which would lead lenders to believe this particular borrower has a high risk of default.

Exogenous Models

Exogenous models of credit risk place greater emphasis on the impact of external factors on the likelihood of default. External factors might include a particularly difficult economic climate or high unemployment rate, for example. Essentially, exogenous factors typically apply to a particular market as a whole.