Credit Risk Definition

The term credit risk generally refers in finance to the risk of a debtor's payment default. In retail banking, for example, credit risk concerns the likelihood that a borrower or debtor will become unable or unwilling to make payments, i.e. a payment default by the respective borrower.

Financial institutions use complex calculation methods to assess the risk when a loan application is submitted, so they can determine and plan the interest conditions and margins of their offers as accurately as possible. In this way, potential losses can largely be avoided. These methods are also part of credit risk management. Every lending institution has an internal credit risk management system.

Credit risks are also an important factor at higher levels in the financial sector. For example, there are various rating agencies that classify the creditworthiness of large companies and countries into different grades. If a country is considered economically and politically stable, the credit risk of its sovereign debt is rated as low. Here the credit risk is referred to as country risk. Country risk can particularly affect foreign loans. This, as in the retail sector, has a significant influence on the interest terms granted for loans.

There are different key figures for credit risk. These include PD (probability of default), EaD (exposure at default) and LGD (loss given default). The abbreviations come from English: PD (probability of default), EaD (exposure at default) and LGD (loss given default).

Credit risk in the private customer sector

Financial transactions in the private customer sector are diverse and complex today. From consumer loans to mortgages and credit cards, there are many products that expose the lender to credit risk. To calculate the probability of a default in this area, a variety of methods and instruments are used.

A particularly important factor in credit risk is the customer's previous credit history. For this purpose, a Schufa report, for example, can be requested. This lists previous liabilities and their repayment, so that lenders get an initial impression of the applicant's ability to pay.

In most cases, proofs of income and bank statements are also provided to demonstrate creditworthiness. Checking income documents gives the bank some security for the loan transaction with the respective borrower. If a customer cannot obtain a loan from a conventional bank because of their credit rating, it may be worthwhile to consider other options, such as special loans without Schufa or loans from abroad. In some cases the interest terms for a loan without Schufa may be somewhat less favorable, since the credit risk is often assessed as higher there, but such a loan can still be sensible in some circumstances, especially for a long-term investment.

Lenders also often use so-called loan securities. These include, for example, guarantees. A guarantee can reduce the bank's credit risk because a guarantor can take over the payments.

Prospective borrowers should in any case take some time to research different possibilities and options so they can obtain the best possible loan for their plans and keep potential risks low.

Reducing credit risk

Those who want to minimize their personal credit risk and thereby increase their chances of obtaining a favorable loan should ensure they do not produce negative entries in the Schufa. Outstanding liabilities should always be settled on time, and the current account balance should, where possible, remain within the agreed limits.

If customers still cannot obtain a loan, it may be useful to involve a close relative or friend as a guarantor. This reduces the bank's credit risk and may make better interest terms available.

Credit risk in the business customer sector

Complex instruments are also used in the business customer sector to better assess the risk of an individual loan application. Capital may be requested for a variety of reasons, for example for a planned expansion or a start-up idea.

For the lender, a decisive factor regarding credit risk is the likelihood of sustainable business success. Which factors play a role depends heavily on the nature of the respective project.

To best assess a company's financial situation and prospects and to avoid potential risks, lenders usually require a detailed business plan. Those who have difficulty preparing one can obtain professional advice from several public bodies, such as chambers of commerce. A good business plan should show how the borrowed capital will be used and how repayment can be managed in the future.

Factors that influence business credit risk

The legal form of the company is also important, as there are major differences in terms of the entrepreneur's liability. For established companies, lenders usually request access to accounts from past years; sometimes tax assessments are also included.

Additional personal liability or the use of real estate and larger assets as collateral can be a good way in this area to minimize credit risk and thus obtain an attractive loan.

In some industries, entrepreneurs also have the option of obtaining a guarantee from an entrepreneur fund so that business ideas that are rather unusual and carry a higher credit risk can also be realized.

Credit risk in real estate

Many people dream of owning their own home, not least to provide for old age. Those who want to buy or build a home usually rely on a mortgage to finance their plans. In this area, however, credit risk depends not only on the applicant's creditworthiness; the loan-to-value ratio of the property to be financed is also important.

Generally, borrowers contribute an equity share of around 10–30% to a construction loan. The higher the equity, the lower the credit risk and thus the lower the risk of loss for the bank. A certain level of equity is important to secure the loan against potential risks.

If the house, for example, has to be sold at a later date, equity ensures that the mortgage can be fully repaid even if the value of the property has fallen slightly or larger costs are associated with the sale.

Prospective buyers should also be able to demonstrate that they are adequately insured and could cover financial burdens such as sudden illness. To minimize credit risk or these dangers, accident insurance and disability insurance are, for example, sensible.

In this way, homeowners can insure themselves against risks such as loss of earnings due to illness or accidents. If the borrower or debtor has a family, they should, for safety, protect against the risk of death with a term life insurance policy.

Since a real estate financing is a very long-term financial product, it is particularly important to find the mortgage that best matches one's wishes and circumstances. Although the applicant's creditworthiness plays an important role, self-employed people or those with little equity should not immediately give up the dream of owning a home.

Some lending institutions have developed special financing offers, such as 100% financing, to help more customers buy their desired property. Here too, guarantors can be used in case of creditworthiness difficulties to reduce credit risk and enable better interest terms.