LO 16.1: Define credit risk and explain how it arises using examples.

LO 16.1: Define credit risk and explain how it arises using examples.
Credit is an agreement where one party receives something of value and agrees to pay for the good or service at a later date. The word credit is derived from the ancient Latin word credere, which means to believe or to entrust. The creditor must have knowledge of the borrowers character and reputation as well as his financial condition. Generally, there is not a definitive yes or no answer to whether a borrower can and will pay back a loan. As such, the lender must address the question of likelihood. The lender must assess the likelihood that the borrower will pay back the loan in accordance with the terms of the agreement.
Professors Note: Borrower, obligor, counterparty, and issuer are all used to signify the party receiving credit. Lender, creditor, and obligee are primarily used to signify the party granting credit.
Credit risk is the probability that a borrower will not pay back a loan in accordance with the terms of the credit agreement. The risk can result from:
Default on a financial obligation. An increased probability of default on a financial obligation. A more severe loss than expected due to a greater than expected exposure at the time of a
A more severe loss than expected due to a lower than expected recovery at the time of a
Default on payment for goods or services already rendered (i.e., settlement risk).
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Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
Credit risk arises in many personal and business contexts. In fact, nearly all businesses, except small firms that confine their businesses to cash and carry transactions (i.e., a good or service is exchanged simultaneously for cash), incur credit risk. Specific contexts in which credit risks arise include:
A person or company performs a service and sends a bill for payment of the rendered service. For example, a car dealership fixes a persons car and then bills the customer, giving the customer 30 days to pay the bill in full without incurring financing charges. A party pays in advance for goods or services and awaits receipt of the goods or services
(i.e., the settlement of a transaction). For example, a university pays in advance for computer training for its staff and faculty and then receives the training over the course of the following year.
A person or company has provided a product and is awaiting payment for the item.
Trade credit is an example of this type of transaction. The firm selling the product offers terms of credit, allowing the purchaser a reasonable period of time to pay the invoice. Big-ticket items are almost exclusively sold on credit. For example, a chemistry firm buys several powerful microscopes from a supplier and is allowed to pay the full balance in 30 days.
There are two types of risks associated with these transactions. There is settlement risk, the risk that the counterparty will never pay for the good or service, and a more fundamental financial obligation that arises from the loan agreement. Credit risk that arises from trade credit is nearly indistinguishable from the credit risk that banks incur. Financial analysis must be performed in both cases to increase the likelihood that the borrower will fulfill the financial obligation. Banks cannot avoid credit risk; it is central to their business. There is no cash and carry model in banking. Banks accept money from depositors and other sources and lend the money to individuals and firms. Because banks cannot avoid credit risk, they must manage the risk through credit analysis and the use of risk mitigants such as collateral and loan guarantees.
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