Credit Risk and Investments..!

Credit Risk and Investments..!

By Ms. UMA SHASHIKANT, CIEL

Whether it's on the stock exchange, in a bank or in a debt fund, credit risks are everywhere.

Care and diligence can go a long way in mitigating them

Credit risk is a big deal these days.

While being rightly en raged about wilful defaulters who seem to be getting away with it, and asking for better lending practices for everyone, we fail to grasp the inherent complexity in the credit business. It might help us as investors to remain realistic amid all the din surrounding defaults.

Formal lending practices are built to make reasonable assumptions about the future prospects of the borrower. Working capital loans make assumptions about realisable values of current assets; personal and credit card loans make assumptions about future personal income; and home loans and asset-based loans assume that the future value of the asset will cover the loan.

Lenders use past data and their analysis of businesses to make these assumptions. It is important to see that there are no guarantees here.

UMA SHASHIKANT, CIEL

It is also important that care and diligence are exercised before a loan is made. Regulations prescribe the processes, disclosures and penalties to ring-fence this risky business of lending against an unknown future.

The risk of unexpected events, including changes in the ability and willingness of the lender to choose well and the borrower to keep commitments is always present. Can this risk be mitigated? Let me offer three situations to illustrate the different approaches to default risk.

Consider the stock exchange. A transaction takes place between the buyer and the seller at a given price.

The seller expects the price to fall, and the buyer expects the price to rise. The settlement of this trade happens later (t+3), by which the time one of the parties has a high propensity to default.

 Someone who bought a share for Rs. 100 has to keep his commitment to pay up, even if the market price when his settlement is due turns out to be Rs. 90. He faces an immediate loss of Rs. 10 on meeting his commitment. Bourse trades thus are transactions with a high default risk.

The stock exchange's clearing house takes 2 primary steps to mitigate this risk.

First, it asks members to deposit some money in advance as capital. The value of trades they can enter into is linked to this deposit, which will be used to make good any defaults.

Second, as the prices of the stocks move, mark-to market margins are imposed and collected.

This takes care of any defaults beyond the initial deposit. The net effect is that any changes in the value of the asset at the end of every trading day , is secured by the clearing house.

Therefore, traders do not worry about default and settlement is guaranteed by stock exchanges.

Consider a bank that is in the business of lending. Its primary risk is that the loans (assets) it holds may turn out to be bad.

The capital that a bank has to hold is similar to the initial deposit the broker has to hold. The amount of loan a bank makes is linked to this capital and it is expected that any loss in the value of the assets will be lower than the amount available as capital.

What the bank does not have is the facility to mark its assets to market. It holds the loans at book value.

 As its borrowers' business turns bad, the bank simply waits for interest payments. It then classifies the asset as non-performing and begins to write off the bad loan.

By structure, a bank manages credit risk after such risk has fully manifested. 

Therefore, the capital is all a bank has to protect itself. The depositor is protected only as long as bad assets do not erode its capital.

About the author..!

-         The writer is MD, Centre for Investment Education and Learning

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