Credit risk simply defined as the probability of loss due to a customer’s failure to make payments on any type of debt. The risk accrues to the suppliers of goods , finance and services and relates to loss of principal and interest, disruption to cash flows as a result of delayed payments and increased collection costs. The loss resulting from credit risk may be complete or partial and can arise in a number of circumstances including the following;
- Where a customer may fail to make a payment due on a debt, credit card, line of credit, or other loan where a customer is unable to repay asset-secured fixed or floating charge debt
- Where a business or consumer does not pay a trade invoice when due
- Where a business does not pay an employee’s earned wages when due
- Where a business or government bond issuer does not make a payment on a coupon or principal payment when due
- Where an insolvent insurance company does not pay a policy obligation
- Where an insolvent bank won’t return funds to a depositor
- Where a government grants bankruptcy protection to an insolvent consumer or business
- Where in the case of cross-border obligations, any default arising from the flow of foreign exchange and/or due to restrictions imposed on remittances out of a country Credit Risk Management
Reduction of credit risk
The credit risk can be reduced in the following ways;
- Adequate credit management
- Performing a credit check on the prospective borrower
- The customer taking out appropriate insurance
- Obtaining adequate security which can be easily realized
- Guarantees by a financially strong third party
Common Causes of Credit Risk
- Credit Concentration – relating to concentrating credit on a few customers or sector
- Ineffective credit appraisal processes
- Credit Exposure in the market and liquidity-sensitive sectors
Challenges in credit risk management
- Lack of information on the potential customers for credit appraisal purposes
- Ineffective risk mitigation strategies.
- Lack of capacity for risk management in terms of human resources and tools to apply
Conclusion
To effective manage credit risk there is need to gain a complete understanding of the customers overall credit risk by viewing risk at various levels.
Author
Kasemiire Agnes Akiiki
kasemiire25@gmail.com
