UNDERSTANDING CREDIT RISK

WHAT IS CREDIT RISK?

Credit risk is the risk of loss that may come from the failure to abide by their terms and conditions by any party in any financial contract. Usually, the failure to make the required payments on loans due to an individual, corporation or entity.

Playing the role of an intermediary, the project finance division of a financial institution or bank is exposed to risks that are specific to its trading and lending businesses and the environment within which it operates. The prime aim of project finance in risk management is to ensure that in measures, understands and monitors the different risks that arise and that the entity adheres strictly to the procedures and policies established to address these risks. Firms have a proper credit approval process which includes a well established procedure for credit appraisal.

WHAT FACTORS ARE USED TO ASSESS CREDIT RISK?

In order to make an assessment of credit risk associated with any financial proposal, the concerned division of the firm first assesses a variety of risks related to the borrower and the respective industry. The borrower credit risk is evaluated by considering the following things:

• The borrower's relative market position and operating efficiency.
• The quality of management, by analysing its payment record, financial conservatism and track record. 
• The financial position of analysing the quality of its standalone and consol financials, its past performance, its financial flexibility in terms of the ability to raise funds.

Industry related credit risk is evaluated on the basis of

• The competitiveness of the sector
• Certain sector specific financials, including RoCE (Return on Capital Employed), earnings stability and operating margins.
• Certain industry features, such as the significance of the industry to the economic growth and government policies relating to the sector or industry. 

WHAT IS CREDIT RISK MANAGEMENT?

Managing credit risk requires supervising and monitoring your customers' business credit as a larger picture of the financial health. You may want to be assured that you will be paid for the services or goods provided. Credit risk management is the process of lowering the amount of risk of customer non payment by providing reasonable terms and limits. There are a lot of components involved in managing risks but it is important to have a process in place. Some enterprises use third party tools to show the status of their accounts receivable. These can display outstanding amounts, ageing reports, and average payment time.

HOW ARE CREDIT RATINGS USED?

After conducting an analysis of the borrowed risk, the credit risk evaluation group assigns a credit rating to the borrower. Usually, firms accept a scale of rating ranging from AAA to BB which varies from firm to firm and an additional default rating. Credit ratings are a very significant input for the approval process, as they help the firm to determine the desired credit risk, spread over the funds cost by considering the credit rating and the default pattern corresponding to the ratings. 

Every proposal for a facility is reviewed by the apt industry expert and specialist in the credit risk management industry before being submitted for approval to the apt approval authority. Usually, the approval process for non fund facilities is identical to that of fund based facilities.