Measure the credit risk of banks through the analysis of the company’s financial situation.

Market Analysis

A credit institution as defined in French law is a legal person that carries out banking operations as its usual profession, regardless of whether they are of the same type. In this respect, this definition differs from that provided for in Community law from 1977 onwards, according to which a credit institution is an undertaking whose activity consists cumulatively in receiving deposits from the public and granting loans for its own account. What about defined credit risk?

credit risk definition

The bank is a category of credit institution which, in general, is entitled to receive funds from the public on demand or within two years of maturity, and which may carry out all the banking operations defined in Articles L. 311-1 and following from Monetary and financial code. Any bank approved in this capacity by the Credit Institutions and Investment Firms Committee is required to join the Fédération bancaire française and the French Banking Association, which is now an employers’ union.

The banks have long been the only ones to provide financing to the economy by systematically transforming their deposits into long-term loans. Today they face strong competition from financing direct via the financial market. Nevertheless, they remain the main supplier of credit to small and medium-sized enterprises.

Another important target for the bank is the liberal professions. A liberal professional carries out an intellectual activity in complete independence, supported by professional secrecy, which is a guarantee for the client. The recipe for their activity is the result of their personal work.

The main activity of a bank is to offer loans, so this is the first risk it faces in the case of non-repayment. A credit authorization is an agreement by which a bank makes funds available to its customer for a specified amount and duration. This credit offer is based on trust both for the creditors who believe in the bank and its potential to lend money to it and for the debtor – the bank – who gives a positive opinion about the customer.

She considers that he is honest and will honour his commitments. Unfortunately, the risk of default, see the abuse of credit, which is a criminal offence under Article L. 241-3 4 of the French Commercial Code, which punishes the director of a company who, in bad faith, uses the company’s credit in a manner contrary to the company’s interests and for personal purposes.

Both are omnipresent risks to which the bank must be aware, for its good financial health but also for the economy in general. The actions of a bank have repercussions on other credit institutions. The bank, like all companies, is looking for a significant profit and that’s why it takes risks. To limit this excess, there is strong banking regulation at the global level, and more particularly at the European level with the Basel Committee.

Credit risk is still the main risk in a bank’s balance sheet today. On average, it consumes around three-quarters of regulatory capital. Credit risk (definition credit risk) is thus subject to strong control, and the bank sets up numerous financial tools and products to manage it:

  • The internal and external rating system for credit transactions.

  • One of the main techniques used by the bank is the analysis of the financial accounts of companies requesting credit. It uses financial analysis. The objective of financial analysis is of interest to many economic agents (the manager, suppliers, bankers) whose concerns are guided by sometimes divergent interests but always conditioned by the good or bad functioning of the company that brings them into contact. The purpose of a company’s financial analysis is therefore to assess risks and identify real needs. The analysis technique is used to determine whether the main balances of a business are respected, whether the activity and profitability are at a satisfactory level and whether the trend it is experiencing is favourable or unfavourable. The banker must take into account the risk of non-reimbursement. It corresponds to the loss of resources committed as a result of the beneficiary’s default. While the state of non-payment may be sudden, it is often preceded by warning signs. To protect against this risk, the banker will seek guarantees, either real or personal, or linked to the credits granted. Fixed asset, interest rate and exchange rate risks are more the result of the bank’s sound internal management. But influence credit granting. Fraud risk (credit risk definition) which is increasingly constraining for banking institutions.

After analysis the banker decides on the possibility to offer credit under certain guarantees. Guarantees are a legal technique designed to provide the creditor with a greater security of payment. These guarantees cover the customer’s risk of default. The risk of default may result in late payments or partial or total non-payment of principal and interest.

Credit risk (credit risk definition) also called counterparty risk is the risk that the debtor defaults or that his economic situation deteriorates to the point where he has to devalue the claim that the institution has on him. Any agent may be affected by this risk, whether it is the company because its supplier does not reimburse it for an advance on goods or the bank that does not reimburse it because the company does not fulfil its commitment.

This risk of default may be voluntary or involuntary, in fact when the company does not get reimbursed it is difficult for it to honour its commitments, there is a chain reaction. Credit is the result between two agents, the lender (credit institutions) and the borrower (the customer), with the product (the loan) representing the risk as a key element. This risk is measured by a weighting of the total amount of outstanding amounts and by the quality of the debtor.

Credit risk is therefore the risk of loss to which a bank is exposed in the event of deterioration or default by the counterparty. It results from the combination of three factors: the Counterparty risk, the Exposure risk and the Recovery risk (CER model).

definition credit risk

Although the bank’s main activity is credit granting, it is not limited to it. It collects deposits, provides a payment service, and participates in various market activities through a securities portfolio. These various activities expose it to numerous financial risks, the five main ones being: 

  • market risk is due to uncertainties about the position of the bank’s portfolios after a given period of time. Uncertainties arise from factors underlying market risk such as interest rates, exchange rates, equity prices, and commodity prices.

  • The liquidity risk. The bank finances its long-term loans with short-term deposits, and in the event that depositors want to withdraw their money they must quickly liquidate these assets.

  • The operational risk related to a dysfunction of internal systems, human errors or fraud.

  • The legal risk related to the non-performance of a contract in the event of bankruptcy.

  • The credit risk, in the event that the debtor is not able to meet all or part of his contractual obligations.

Face at its risks, the bank must protect itself. Poor risk management can lead to bankruptcy and have consequences for the global economy. It must therefore make a trade-off between the risk taken and the resulting gain. In view of the crucial role of banks for the proper functioning of the economy, the risks taken should not be excessive. Like any company, the bank seeks to make a significant profit, but for the bank, a larger profit means taking more risk.

Ghislaine TOVIHO

BONDS & SHARES

BONDS & SHARES is a participatory non-Profit information platform for, through and by experts in finance and business. For more information please visit www.bonds-and-shares.com


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