A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.
Losses can arise in a number of circumstances, for example:
- A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan.
- A company is unable to repay asset-secured fixed or floating charge debt.
- A business or consumer does not pay a trade invoice when due.
- A business does not pay an employee’s earned wages when due.
- A business or government bond issuer does not make a payment on a coupon or principal payment when due.
- An insolvent insurance company does not pay a policy obligation.
- An insolvent bank won’t return funds to a depositor.
- A government grants bankruptcy protection to an insolvent consumer or business.
Credit Risk Rating
The term credit rating refers to a quantified assessment of a borrower’s creditworthiness in general terms or with respect to a particular debt or financial obligation. A credit rating can be assigned to any entity that seeks to borrow money an individual, a corporation, a state or provincial authority, or a sovereign government.
Types of Credit Ratings
All credit agency agencies use various terminology for determine credit ratings. However, the notations are very similar. Ratings are always grouped into two: an ‘investment grade’ and also a ‘speculative grade’.
These ratings mean that the investment is a solid one and the issuer will most likely meet the repayment terms. These investments are priced less as compared to speculative grade investments.
These investments are known to be high risk. So, they come with higher interest rates.
Importance of Credit Rating
When a credit rating agency upgrades a company’s rating, it suggests that the company has a high chance of repaying the credit. On the other hand, when the credit rating gets downgraded, it suggests the company’s ability to repay has reduced.
Once the company’s credit rating has been downgraded, it becomes difficult for the company to borrow money. Lenders will consider such companies as high-risk borrowers as they have a higher probability of turning into a defaulter. Financial institutions will hesitate to lend money to the companies with low credit rating.
- It allows investors to make a sound investment decision after taking into consideration the risk factor and past repayment behaviour. In other words, it establishes a relationship between risk and return.
- Credit rating does a qualitative and quantitative assessment of a borrower’s creditworthiness.
- In the case of the companies, credit ratings help them improve their corporate image. It is useful especially for companies that are not popular.
- Lenders such as banks and financial institutions will offer loans at a lower interest rate if the entity has a higher credit rating.
- The credit rating acts as a marketing tool for companies and also as a resource that is helpful at the time of raising money. It reduces the cost of borrowing and helps in the company’s expansion.
- Credit rating encourages better accounting standards, detailed information disclosure, and improved financial information.
Credit Worthiness of Borrower
Creditworthiness, simply put, is how “worthy” or deserving one is of credit. If a lender is confident that the borrower will honour her debt obligation in a timely fashion, the borrower is deemed creditworthy. If a borrower were to evaluate their creditworthiness on her own, it would result in a conflict of interest. Therefore, sophisticated financial intermediaries perform assessments on individuals, corporates, and sovereign governments to determine the associated risk and probability of repayment.
Financial institutions use credit ratings to quantify and decide whether an applicant is eligible for credit. Credit ratings are also used to fix the interest rates and credit limits for existing borrowers. A higher credit rating signifies a lower risk premium for the lender, which then corresponds to lower borrowing costs for the borrower. Across the board, the higher one’s credit rating, the better.
A credit report provides a comprehensive account of the borrower’s total debt, current balances, credit limits, and history of defaults and bankruptcies if any. Due to high levels of asymmetries of information in the market, lenders rely on financial intermediaries to compile and assign credit ratings to borrowers and help filter out bad debtors or “lemons.”
The independent third parties are called credit rating agencies. The rating agencies access potential customers’ credit data and use sophisticated credit scoring systems to quantify a borrower’s likelihood of repaying debt. Lenders usually pay for the services, but borrowers may also request their credit score to gauge their worthiness in the market.
A limited set of credit raters are considered reliable, and it is due to the level of expertise and data consolidation required, which is not publicly available. The so-called “Big Three” rating agencies are and Fitch, Moody’s, and Standard & Poor’s. These agencies rate corporates and sovereign governments on a range of “AAA” or “prime” to “D” or “in default” in descending order of creditworthiness.