What Is Credit Risk? Understanding Its Impact On Singapore’s Banking System
October 11, 2023
Credit risk management is an integral component of running a business. If businesses want to maximise sales prospects while maintaining financial security, they must strike an accurate compromise between the risks of extending loans.
In this article, we define what is credit risk and credit quality, how banks in Singapore manage country risk, and the five Cs of Credit in Singapore.
Credit Risk Definition
Credit risk is the possibility of monetary loss due to a borrower’s default on a loan. Essentially, it is the danger that a lender won’t get the principal and interest they’re due after they extend credit.
This would disrupt their cash flow and raise their collection expenses. Lenders can reduce their exposure to credit risk by considering the borrower’s income and other financial obligations.
While it’s hard to predict who will specifically breach their responsibilities, correctly evaluating and mitigating credit risk can decrease the magnitude of a financial loss. An investor or lender receives interest earnings from the debt obligation’s issuer or borrower as compensation for taking on the underlying credit risk.
Key Takeaways Relevant To Singapore’s Market
The key takeaways include:
- The probability that a loss may be incurred by the lender as a result of making a loan to a borrower is what is defined as the potential credit risk.
- The five Cs of consumer credit risk are the consumer’s credit history, ability to repay the loan, capital and terms and conditions, and collateral.
- Poor credit borrowers typically pay higher interest charges on loans.
- Lenders will look at your credit scorecard as one factor among many when determining your credit limits and default risk.
Understanding Credit Risk Within Singapore’s Banking System
There is always the potential that a bank borrower may fail to make payments on a loan, whether it’s credit cards, mortgage, or something else entirely. Offering credit to a customer also exposes businesses to the possibility that those customers and counterparties won’t pay their bills on time.
The probability of risk of default that results when the borrower or counterparty will fail to meet its obligations in accordance with agreed terms is set by the borrower’s capacity to pay back the loan in full and on time.
Lenders often use the five Cs of credit (associated collateral, capacity repayment, credit history, condition of loan, and capital.) to evaluate a consumer loan’s concentration risk.
Some businesses have separate divisions whose sole purpose is to evaluate the financial stability of existing and new clients. The rapid analysis of client credit risk profiles has become possible by technological advancements in the corporate world.
Role Of Bond Credit-rating Agencies In Singapore
Companies that specialise in bond credit ratings do so by assessing the creditworthiness of corporations and local governments that issue bonds. A bond’s credit rating is a crucial consideration for every potential buyer.
Suppose a bond’s rating is below investment grade (<BBB); then the bond issuer faces an above-average probability of default. If it has a higher rating (such as BBB, AAA, AA, or A), default is less likely to occur.
Credit Risk Versus Interest Rates In Singapore’s Economy
If a lender evaluates a borrower as having too high credit risk, they may choose not to lend to them. For instance, a mortgage applicant with a strong credit scoring models and consistent income can look like having a low credit risk.
Thus, they’ll probably get a cheap interest rate. However, a low credit score candidate may need to engage with substandard financial institutions.
A higher credit score is the greatest bet for a bank borrower or counterparty in a high-risk category to secure a loan with more favourable terms. If your credit isn’t good, you might want to talk to a credit restoration service.
On the other hand, issuers of bonds with lower credit ratings provide greater interest than lenders with impeccable credit ratings. Participants with less favourable credit ratings leverage high yields to convince investors to accept the credit risk that comes with their offers.
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How Do Banks In Singapore Manage Credit Risk?
There are a variety of methods that may be used in credit risk control by banks. They can impose strict lending criteria, such as a minimum borrower credit rating.
They may then keep tabs on their loan portfolios regularly, allowing them to react swiftly to developments in the creditworthiness of their clients.
What Are The Five Cs Of Credit In Singapore?
The Five Cs of Credit is a standard model that comprehends, evaluates, and lessens credit risk. The five c’s that help in the decision process are:
The capability of a borrower to incur and repay debt is what this term refers to. One can use several coverage ratios and debt services to evaluate a consumer or business borrower’s financial stability.
Knowing the applicant’s competitive edge is essential for commercial financiers because the advantage directly affects the company’s future cash flow generation potential.
Is the borrower reputable, and trustworthy if they are a private individual? Commercial borrowers’ character refers to the integrity and trustworthiness of the business’s leadership and, in the case of privately held corporations, the ownership group as a whole.
Conditions include the goal of financing, extrinsic events, and other elements of the outside world that could present hazards or possibilities for an applicant for credit.
Political and macroeconomic conditions and the current phase of the business cycle can all play a role. Challenges unique to the borrower’s industry and changes in society or technology that may impact the borrower’s competitive position are examples of circumstances.
A client’s net wealth or general financial stability is a frequent description of capital. Lenders will want to know the correlation between debt and equity are backing up the applicant’s assets.
Finding out if the borrower has access to any other funding options is also crucial. For instance:
- Does the corporate borrower have access to cash assets from any affiliated companies?
- Can a parent or other relative of the individual borrowing the money (who may not have an extensive credit history) guarantee the loan?
Collateral securities and derivatives play a critical role in how loans are set up to reduce credit risk. The asset quality, location, ease of transferring title, and acceptable LTVs in the event of liquidity of a company are just a few of the many factors one must understand.
Unlike unsecured loans, these loans must have collaterals to ensure that required payments are made.
Management Of Credit Risk
Assessing and managing credit risk is a multiple-stage procedure, although one can consolidate into two distinct phases:
Lenders evaluate borrowers’ creditworthiness via proprietary risk evaluation algorithms that vary by enterprise or location and the kind of borrower (consumer vs. commercial).
Lenders in the personal loan industry have an interest in learning about the borrower’s overall financial picture:
- What assets and liabilities (overdrafts) does the individual have?
- How much money do they make (in comparison ratio to their other commitments)?
- If they have common credit, past due credits, and how good their credit history is.
Guarantees and collateral are standard in personal loans. However, commercial lending is significantly more intricate, and the sums businesses borrow are typically much bigger than those individuals take out.
One can use several quantitative and qualitative methods to provide a counterparty credit risk assessment to a commercial client. Classifications of qualitative risk analysis include:
- Knowledge of current events in the business world and the economy at large.
- Industry analysis of the borrower’s business.
- Analysing the company in and of itself, looking at its approach to expansion and competitive advantages.
- Examining and getting to know the company’s management committee and founders (if applicable). The analysis by credit officers will factor in the management team’s track record and the owners’ credit ratings.
Financial analysis is responsible for the quantitative component of the risk-based material credit evaluation. Lenders look at some financial ratios and performance when assessing a borrower’s financial stability.
Without proper precautions, a lender may incur loan losses, which would have a negative impact on the bottom line of a company that provides financial services. Lenders employ a wide variety of techniques to reduce their exposure to credit risk (and consequently, loan loss), including the following:
- Credit Structure
Credit structuring approaches can reduce some of the risks that come with credit. Credit structure factors include collateral security, amortisation schedules, loan covenants, and loan-to-value ratios (LTVs).
- Sensitivity Analysis
Lenders often do a sensitivity analysis, which alters various aspects of a particular credit structure to evaluate how the applicant’s credit risk might change under multiple hypothetical circumstances.
- Portfolio-Level Controls
The methodology includes keeping track of the percentage of the loan portfolio that makes up a specific credit type or the number of borrowers that fall inside that credit risk category.
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Final Thoughts In Singapore’s Context
Credit risk is the risk and the possible financial loss that a lender may face due to the possibility of a debtor defaulting on the loan. Banks and lenders consider multiple variables when evaluating the level of risk associated with a borrower.
They encompass elements such as earnings, debt obligations, and track record of loan payback. If a lender perceives an individual as having a higher credit risk. In that case, the likelihood of loan approval decreases, and the probability they will charge a higher interest rate upon approval increases.