Credit Risk

Credit risk is the chance that a borrower will not repay as agreed. If the borrower pays late or stops paying, the lender loses interest, principal or both, plus collection costs.

US bank examiners at the Office of the Comptroller of the Currency (OCC) define it as the risk to a lender's financial condition from a borrower's failure to meet the terms of its contract.

Lenders often think of credit risk as two questions. How likely is a default? And if one happens, how much will we lose after selling collateral or calling a guarantee?

Worked example. A lender makes 100 loans of $50,000 each. If it expects 4 of them to default and to recover half of each through collateral, the expected loss is 4 × $25,000 = $100,000, or 2% of the $5 million book. That expected loss feeds pricing and the reserve.

Why it matters for lenders

Credit risk is the main risk in any lending business. It drives what rate to charge, how much collateral to require and how much capital to hold. It also sets the size of the allowance for losses under the current expected credit loss (CECL) standard.

There is no single official list, but credit risk management is often described in eight steps:

1. Set written credit policy and risk appetite.
2. Analyze each borrower before approval through credit analysis.
3. Approve within set authority limits.
4. Grade each loan with a risk rating.
5. Reduce risk with collateral, guarantees and covenants.
6. Monitor payments, financials and covenants after closing.
7. Manage the whole book for concentration risk and trends.
8. Report to the board and funders, and act on problem loans early.

Steps 1 to 4 control risk going in. Steps 5 to 8 control it after the money is out the door, which is where many lenders fall short.

How it works in practice

A community lender approves a $250,000 loan to a trucking company. The underwriter checks cash flow, the owners' credit and equipment values, and assigns a pass grade. Approval rules require a personal guarantee and quarterly financial statements.

Six months later, fuel costs jump. The servicing team sees two late payments and a missed financial report. The loan is regraded, the lender asks for updated numbers, and the account officer meets the owner to talk through options.

In a spreadsheet setup, the missed report goes unnoticed until year-end review, and the grade stays at pass far too long. When reporting deadlines, payment history and grades sit on the same loan record, warning signs surface in weeks rather than months.