A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. The risk arises from the occurrence of some expected or unexpected events in the economy or the financial markets. Credit analysis is the evaluation of this credit risk and may relate to an individual transaction or to a borrower’s overall creditworthiness.
Credit analysis seeks to provide a fundamental view of a company’s or an individual’s financial ability to repay its obligations. Factors that would be considered or looked at for a company are operating margins, fixed expenses, overhead burdens, and cash flows to access the credit analyses.
The general approach of most businesses when undertaking the credit analysis of an individual or another business is to use credit ratings that are prepared by the major credit rating agencies.
The type of risk is derived by estimating the probability of default by the borrower at a given confidence level over the life of the facility, and by estimating the amount of loss that the lender would suffer in the event of default.
Risk can also arise from staff oversight or mala fide intention. 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 other important risks are liquidity risk, business risk, and reputational risk. Systemic risk and moral hazard are unrelated to routine banking operations, but they do have a big bearing on a bank’s profitability and solvency.