Credit risk. Risk mitigation methods

Many factors affect the interest rate on a loan or credit. One of them is credit risk, which is completely different for each borrower. What influences them? How to minimize them? Check.

What is credit risk? Types of credit risk

What is credit risk? Types of credit risk

Everyone who has taken out a car loan, mortgage or other liability has come across the concept of credit risk. What does it mean? It specifies the risk that one of the parties – the lender or borrower – may fail to fulfill its obligations which were included in the contract. There are four types of credit risk:

  • active risk
  • passive risk
  • individual risk (single),
  • total (portfolio) risk.

Active risk is the probability that the borrower will not comply with the terms of the loan agreement without any certificates or credit. For this reason, non-bank institutions that allocate e.g. a loan check the creditworthiness of a potential borrower. Passive credit risk is the opposite. It means that there is a danger that the institution will not be able to raise funds for loans. This situation may occur in connection with the bank’s image crisis – when the institution’s clients pay their deposits.

A single credit risk is a possibility that the borrower will not repay the loan in full or will do so later than the one indicated in the repayment schedule. On the other hand, the portfolio credit risk depends on all individual risks taken by the financial institution.

Factors that may affect credit risk

Credit risk is calculated based on the creditworthiness and history of the lender at the Credit Information Bureau. Both banks and lending companies take into account several factors when checking their clients ’creditworthiness. To calculate the consumer’s financial capacity, loan companies check the amount of all customer revenues as well as all liabilities they pay and the amount of monthly expenses. In addition, they check the borrower’s age and education.

Credit risk mitigation methods

Credit risk mitigation methods

Too high a credit risk may translate into a loss of capital by a financial institution. On the other hand, disturbances in financial liquidity and solvency of an enterprise may contribute to the bank’s bankruptcy. That is why banks use different methods of risk reduction. The most important minimization methods include:

  • analysis of the consumer’s creditworthiness – the amount of earnings and form of employment of the consumer, his financial situation are assessed,
  • verification of customer creditworthiness – credit history in BIK,
  • individual terms of the loan agreement for each customer – less reliable people can get a loan for a lower amount and on slightly worse terms than the one they are applying for,
  • loan insurance by the borrower – this is a favorable solution from the point of view of loan security. If the client cannot repay the loan for certain reasons, the insurance company guarantees the repayment of the liability,
  • creation of bank reserves – accumulation of capital belonging to the bank, which will cover possible losses.

Collateral is also a way to minimize credit risk. Help from a guarantor to take out a loan or car loan collateral may be associated with better contractual terms. In such a situation, in the event of financial difficulties, the lender is more confident that the commitment will be repaid on time.

How to build creditworthiness to reduce credit risk?

How to build creditworthiness to reduce credit risk?

If we plan to make a commitment, we should remember that adequate creditworthiness will help not only to pay off the liability. A positive history in BIK and adequate earnings also affect APRC loans. Our financial situation will improve:

  • timely repayment of previous obligations,
  • giving up excessive amounts of obligations,
  • increasing revenues – e.g. through better paid work or occasional work,
  • creating savings on own contribution (in the case of mortgage loans).

If you don’t have a history at the Credit Information Bureau – it’s worth deliberately creating it. It is enough to take a small installment loan or buy electronic equipment in installments.