Credit risk is a major component that accompanies the stock market. While most of us get upset, even angry, about defaulters who got away with credit risk, we actually have no idea what the credit business entails. Once investors understand the complexity of the credit business, they remain realistic about the stories that surround defaulters.
How lenders work
Formal lenders have built up reasonable expectations about their borrower’s future prospects. Capital loans given for businesses are give out on the basis of the borrower’s personal assets. Credit cards and personal loans assume the borrower’s future personal income. And, asset-based loans such as Home Loans assume that the future value of the asset will cover the loan. Lenders use your past income and calculate Home Loan eligibility or eligibility of other loans to make all of these assumptions.
Before you apply for a loan, it’s important to take care and be diligent. Remember to do your homework and only then apply for a loan. For example, if you want to buy a home, check the Home Loan repayment calculator in India and other details to make an informed decision. The lenders will always prescribe regulations in the process, and will imply penalties to make it known how risky this business of lending to someone with an unknown future can be. There is always the risk of unexpected events that include a change in the market or in the ability of a borrower to choose and repay the loan completely. Is it possible for these risks to be mitigated?
Here are three different situations to exhibit how different institutions approach the risk of default.
The stock exchange
In the stock market, transactions take place between the buyer and the seller at a particular place. The seller expects the price of the product to fall, while the buyer remains hopeful and expects a rise. The settlement, regarding the money, only happens later, but by then one of these parties could possibly default. If a borrower has bought a share worth Rs.300, he must stay committed and pay just that amount. Even if the market price lowers after he has made his agreement and it turns out the share is worth Rs.250, the buyer must still pay the complete amount of Rs.300. But, they will face a loss of Rs.50 on meeting that commitment. Thus, you can see that stock market trades are transactions with a high risk of default.
To lighten these risks, the stock exchange clearing house takes two primary steps. The first is to ask all its members to deposit an advance as capital. So, in the case investors default, the default amount will be taken from this deposit to make up for the difference. The second step is as the prices of stocks tend to move, differences from the market margins are imposed and later collected. This amount will take care of defaults beyond the first deposit. Changes at the end of every trading day are secured by the clearing house, making traders feel safe about defaulting themselves.
A commercial bank that deals with lending comes under risk when its loans and assets turn out to be bad. The capital the bank holds is very similar to the deposit of a buyer that a broker holds. The amount the bank makes from a loan is linked to this capital and it’s expected that if there is any loss in the value of the assets, then it will be lower than the overall capital. These banks, however, do not have the power to level these assets in the market and only hold these loans on book value.
If the borrower’s business is bad, then the lender just waits for interest payments. After this, the loan is written off as bad debt and the asset is classified as non-performing. The bank will only mitigate this credit risk after such a situation occurs. So, the only way the bank protects itself is with the capital.
Insurance activities are divided into broad categories, namely non-life and life insurance. Companies that deal with either of these activities face very different kinds of credit risks. By terms of regulatory rules and business practices, these firms hold different technical supplies based on their activities.
For life insurance companies, their technical provisions form about 80% of their liabilities. Capital has a very small percentage and these firms use their provisions to pay potential claims. Life insurance policies normally let their holders invest in certain assets and even borrow against the value of the policy itself. For non-life insurance firms, their technical provisions make up about 60% of their liabilities. The balance between these provisions and the firm’s capital creates a much higher uncertainty of non-life claims. This proves that both insurance firms have plenty of credit and market risks.
Life insurance companies do not rely on the short-term market for their funding. This is because they’re heavily funded by premiums. The risks they face are normally managed using standard asset-liability management techniques. They do this by imposing constraints on the size and type of investments taken, and balancing maturity mismatches between liabilities and investments.
As different firms become participants in newer markets, they take on more financial risks. To lessen these risks, it becomes important to have a number of procedures and policies in play. But risk management takes places based on each firm’s specific business ideals. Thus the challenge is for risk managers to assume different risks across the firm.