Credit Risk is the risk of default which arises when an entity fails to pay it’ s dues on loans granted by a creditor/ bank. In monetary terms, the loss might be complete or partial in nature. For the creditor, this might mean loss of principal and interest which may further lead to increased collection costs.
An entity (i.e consumer or business) usually defaults on their debts because of following two reasons –
- Loss of payment capacity
- Loss of Intent to repay the debt
Customers might lose their payment capacity due to various reasons such as loss of earnings or wages, bankruptcy, insolvency of bank deposits, health problems etc. Creditors try to assess their customer’s risk based on above factors using various credit risk models. These models help assess the customer’s payment capacity at the time of his loan application as well as throughout the repayment process. When Implemented, these models help the creditor to reduce the combined losses for his portfolio. A good example of this model would be credit score such as CIBIL or FICO score.