Credit risk refers to the risk that an issuer of debt securities or a borrower may default on his or her obligations or that the payment may not be made on a negotiable instrument.
Credit risk grading is the process which helps the sanctioning authority to decide whether to lend or not to lend, what should be the lending price, what should be the extent of exposure, what should be the appropriate credit facility, what are the various facilities, what are the various risk mitigation tools to put a cap on the risk level.
It provides detailed and formalized credit evaluation process for risk identification, measurement, monitoring and control, risk acceptance criteria, credit approval authority, maintenance procedures and guidelines for portfolio management.
CRG is an important tool for credit risk management as it helps the banks and financial institutions to understand various dimensions of risk involved in different credit transaction. It provides a better assessment of the quality of credit portfolio of a bank.
Components of Credit Risk Grading
Financial risk: The uncertainty of future incomes due to the company’s financing. Financial risk management refers to the practices used by corporate finance managers and accountants to limit and control uncertainty in the firm’s total portfolio.
Financial risk management aims to minimize the risk of loss from unexpected changes in the prices of currencies, interest rates, commodities, and equities.
Business/Industry risk: The risk related to the inability of the firm to hold its competitive position and maintain stability and growth in earnings. It is generally measured by the variability of the firm’s operating income over time.
Management Risk: The risks associated with ineffective destructive or under-performing management, which hurts shareholders and the company or fund being managed.
Security risk: Security risk mainly depends on the potential owners or other source. There is some Security risks are given below:
- Enforceability/Legal structure, and
- Forced Sale Value.
Relationship risk: Relationship risk mainly based on supplier and customer relation to the entrepreneur.
If the entrepreneur can make a good relation to the customer or supplier he or she also get the loan at a lower rate.
How to Compute Credit Risk Grading
- Identify all the Principal Risk Components.
- Allocate weight to Principal Risk Components.
- Establish the Key Parameters under each risk components.
- Assign weight to each of the key parameters.
- Add all the weight of the key parameters to have an overall score.
- Assign a grade based on the total weights. The grading method assumes simple weighted average addition of the risk criteria.