3 Types of Credit Risks and How to Manage Them

3 Types of Credit Risks and How to Manage Them

Every individual engaged in business has experienced losses at some point. This is normal because few businesses make a profit in a short period. However, what if these losses result in the business owner failing to repay the capital loan to the bank? This is something to be aware of, and therefore it is important for anyone in business to understand credit risks.

Every business owner certainly wants to avoid bad debts. This will worsen the situation and the image of the business. The bank will also give the worst score, and the most fatal consequence is that the business owner will not be able to apply for a loan again. If this happens, it will be difficult for the business owner to develop the business further.

So, how does the bank manage credit risks for debtors? Here is an explanation of the definition, types of risks, and how to manage them.

Definition of Credit Risk

In general, credit risk is the loss associated with the bank due to debtors being unable or failing to repay loans until maturity. Debtor failure can occur due to two things:

a. Credit exposure. If the loan burdened on the debtor is large, the debtor may not be able to repay the loan according to the applicable terms.

b. Quality of credit exposure. Loan default due to the quality of collateral provided by the debtor. If the collateral value is low, the quality of credit exposure is also low.

Types of Credit Risks

Source: freepik.com

There are three types of credit risks based on the counterparty:

1. Sovereign Credit Risk

Every country has financing with certain funds to carry out government needs. To obtain complete financing, governments usually use funds from within the country and often borrow funds from other countries with applicable terms and conditions.

Credit risk to the government is when a country borrowing funds is unable to repay the loan, even until maturity. This inability to pay is accompanied by interest and penalties according to the applicable agreement.

2. Corporate Credit Risk

This type of credit risk usually occurs in the banking industry. Examples include:

- Default risk from companies receiving loans.
- Default risk from companies receiving equity participation.
- Default risk from debtors who are issuers of bonds.

3. Retail Customer Credit Risk

For the third type, this credit risk can occur when individual debtors fail to make installment payments and are unable to repay. This can happen because the debtor's needs exceed limits, making them unable to make payments.

Credit Risk Management Methods

There are at least six credit risk management methods that you need to understand:

1. Rating Model

This model needs to be applied in business as a means to avoid default by debtors. Therefore, the bank's method is to determine the appropriate risk so as to be accurate in providing credit. By using this method, the bank will avoid potential defaulting debtors.

2. Credit Portfolio Management

Diversification in credit portfolios is highly likely. This needs to be done to avoid the tendency for banks to only lend to certain industries or debtors in certain regions. If able to do so, the risk of default can be minimized. Such analysis can be done in both corporate and individual credits.

3. Securitization

For the banking world, economic fluctuations can occur at any time. To anticipate this, banking institutions need to manage their business activities and capital well. In addition to managing capital, banking institutions can also take other measures, such as selling part of their credit portfolio to the public in the form of securities. This strategy is called securitization, aimed at reducing the high exposure potential to certain types of credit.

4. Role of Collateral

Collateral is security provided by the debtor to the creditor. Collateral can take many forms, but the most popular is cash (physical). However, if cash is not desired, debtors can use collateral such as property.

5. Cash Flow Monitoring

Cash flow can be volatile depending on the situation and conditions of the world economy. Therefore, it is necessary to monitor cash flows to prevent credit situations from worsening at any time. Various banking institutions seek to limit exposure. This method is also known as Exposure at Default.

6. Recovery Management

Every banking institution certainly needs a division that is ready to face payment failures experienced by debtors. They are tasked with handling credit recovery so that banking institutions remain stable in carrying out their other tasks.

Once you understand the definition, types, and management methods of credit risks, you can apply for a loan to start your business. If you work in a financial institution, checking the credit score of potential borrowers is important. Therefore, use Brick to connect with digital financial services. Utilize loan service solutions from Brick to make the checking process easier and faster.

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