When extending credit, whether credit cards, mortgages or other forms of loan, there is always an element of risk that the borrower may default. This chance of loss is called credit risk; the risk of the borrower’s failure to meet the agreed responsibilities or pay back a loan once it has been sanctioned.
That said, credit risk exposure is the maximum potential loss you could suffer if a borrower default on payments. This loss may include lost principal and interest, interference with cash flows, and increased collection costs. Credit exposure can be partial or complete and can occur under different circumstances, including the following:
- A borrower failing to make the required mortgage or credit card payments
- A debtor failing to pay a trade invoice when due
- A company unable to make timely principal payments on debt owed
- A company unable to pay outstanding employee wages or salaries when due
- An organisation failing to pay asset-secured floating or fixed charge debt
While financial institutions can’t run without risks, they can alleviate them. Taking calculated risks is a good strategy for any business to manage risks and survive in the long run. Credit exposure is usually calculated based on certain agreements like long-term contracts or repayment loans.
Understanding your credit risk exposure is the first step to managing your business’s credit risk. Conduct an audit on your operations to identify your credit default risk and implement measures to secure your business and mitigate your credit risk exposure.
Types of Credit Risk
Credit default risk
This is the risk you assume in the possibility that a borrower will not make the required payments on their debt obligation. It often occurs when a borrower fails to fulfil their promise on loan repayment and is already 90 past the due date. All credit-related financial transactions, such as credit derivatives, loans, and bonds, are susceptible to this type of risk.
This is the potential for a loss in value associated with an individual exposure or a group of exposures that is damaging and recovery is unlikely.
Country risk is the uncertainty related to investing in a foreign country. It involves the risk of defaulting on a company’s foreign currency payment obligation and is often associated with a country’s microfinance performance and political stability.
Counterparty credit risk
This is a chance that the counterpart to a financial transaction could not honour the agreement before the final settlement of the agreement.
How to Control Credit Exposure
- Know your customer – Knowing your customer is a concept that enables you to select your customers diligently. You can reduce your credit risk by performing a credit assessment on potential clients before selection. Clients with higher credit ratings are unlikely to default on their debt obligation.
- Set accurate credit limits – Evaluate your customers’ finances and impose accurate credit limits. Check on core indicators such as the company’s financial reports, profits, and net worth to establish your financial health. Also, remember to determine your business’s capital requirements to know its ability to fulfil short-term financial obligations.
- Conduct due diligence to strengthen your credit control function.
- You can also control your credit exposure by introducing stiff measures like penalties and loan products with a higher interest rate.
Protect Your Business With Niche Trade Credit
Niche Trade Credit has provided credit insurance solutions for the past 30 years. If you’re interested in protecting your business on a global scale, please call us at (02) 9416 0670 for assistance.
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