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

A credit institution as defined by French law is a legal person that carries out banking transactions 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.

credit risk

The bank is a category of credit institution which, in general, is authorised to receive funds from the public at sight or within two years of maturity, and which may carry out all banking operations defined in Articles L. 311-1 et seq. of the Monetary and Financial Code. Any bank approved in this capacity by the Credit Institutions and Investment Firms Committee is required to join the French Banking Federation on the one hand and the French Banking Association, which is now an employers’ association on the other.

For a long time, banks were the only ones to provide financing to the economy by systematically transforming their deposits into long-term loans. Today they face strong competition from direct financing 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.

A bank’s main activity is to offer loans, so this is the first risk it faces in the event 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 that the bank must prevent, for its good financial health but also for the economy in general. A bank’s actions have an impact 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 on a bank’s balance sheet today. On average, it consumes around three-quarters of its own funds  regulatory. Credit risk is thus subject to strong control, and the bank is implementing numerous financial tools and products to manage it:

– The system of internal and external ratings of credit operations.

– One of the main techniques used by the bank is the analysis of the financial accounts of companies applying for credit. It uses financial analysis. The objective of financial analysis is of interest to many economic agents (managers, 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 influences the granting of credit. The risk of fraud, which is increasingly restrictive for banking institutions.

After analysis, the banker decides on the possibility of offering 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 payments.

Credit risk, also known as counterparty risk, is the risk that the debtor will default or that its economic situation will deteriorate to the point where it will have to write down the amount owed to it by the institution. 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 can be both voluntary and 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 of the counterparty. It results from the combination of three factors: the Counterparty risk, the Exposure risk and the Recovery risk (CER model).

credit risk definition

Although the bank’s main activity is the granting of credit, it is not limited to this. 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 at the end of a given period of time. Uncertainties arise from factors underlying market risk such as interest rates, exchange rates, equity prices, and commodity prices.

– 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.

– Operational risk related to a malfunction of internal systems, human errors or fraud.

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

– Credit risk, in the event that the debtor is unable to meet all or part of its contractual obligations.

Faced with 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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