Credit risk

Assessing Credit Risk – The Hindu

The promise of higher returns can be misleading. Investors should exercise caution

The promise of higher returns can be misleading. Investors should exercise caution

Rajesh asks his colleague Parag to lend him ₹400. Rajesh assures Parag that he will return the amount in the evening, after he gets a chance to withdraw it from the ATM.

Rajesh only had a ₹2000 note and needed change for his lunch etc. They’ve been friends for years and it was a small thing. Even if Rajesh had said, “I’ll pay you tomorrow,” Parag wouldn’t have been concerned.

In this case, the credit risk for Parag, ie the possibility that Rajesh would not repay the amount, was insignificant. Even if Rajesh had forgotten about him, Parag wouldn’t have cared.

Term of office, risk

Suppose Rajesh said he would pay him back after three months, Parag would have thought that odd. He would not have declined the request to lend the money to Rajesh but a question would have arisen in his mind; this would have implied that there was a credit risk. Yet Parag may still have lent the money. The first principle of credit risk is that as tenure increases, credit risk increases.

Knowledge of the borrower

Now suppose the peon at a nearby office has asked Parag for ₹400. Unless Parag knew about this peon, he might have refused or been a little reluctant to lend.

The next factor to keep in mind is the familiarity of the borrower. If the borrower is not known, the risk is greater.

The examples above were money lent without any kind of security. Often money is lent against collateral, for example, when we lend money to someone by asking the borrower for some kind of collateral. Here, in addition to the borrower, we also assess the quality of the element (asset) given as collateral; if we lend someone money for gold, we want to assess the quality/purity of the gold.

We look at several factors before lending money. The reason we do this is that we want to be sure that the money that has been loaned will be returned to us, and on time. Also, if there is interest to pay us, we would like the same to be paid as well, and on time. All of these checks are aimed at mitigating credit risk.

Just as we lend money to individuals, we also lend to banks; when we deposit money in a savings account, invest in term deposits, etc., we are actually lending it to them. When we invest in bonds, debentures, etc., we are actually lending money to the institution that issues them. It is important to assess the risk associated with this loan. We need to check how safe the principal is and how timely payment of interest will be assured. This can be verified by reading the offer document, in detail. Get details about the institution, its past performance, what its ratings are – there are rating agencies that rate security of principal and timely payment of interest – whether the amount borrowed is secured by certain assets and what is the quality of these assets.

Many times I get asked about investing in a particular type of bond or debenture because they pay about a percentage point or two more. “My standard answer is, how much are you investing and how much more will you earn in terms of money?”

Let’s understand this with an example. Suppose an individual wishes to invest ₹10,000 in a bond which yields 2% more per annum than the bank fixed deposit. The bank deposit is always safe. The higher return in terms of real money means it is ₹200 more per year.

The investor must decide if for ₹200 per year more, it is worth taking this extra risk. In addition, liquidity, that is to say the ease of collection in the event of an obligation, is either impossible or tedious.

A credit risk is the risk of default on a debt that may arise from a borrower not making required payments. So very often, lured by the promise of higher interest income, we end up taking unnecessary credit risk. Always remember that the higher the interest rate, the greater the risk.

(The author is a financial planner and author of Yogic Wealth)