Mitigating Credit Risk

Lenders mitigate credit risk using several methods:

Risk-based pricing: Lenders generally charge a higher interest rate to borrowers who are more likely to default, a practice called risk-based pricing. Lenders consider factors relating to the loan such as loan purpose, credit rating, and loan-to-value ratio and estimates the effect on yield (credit spread).

Covenants: Lenders may write stipulations on the borrower, called covenants, into loan agreements:

  • Periodically report its financial condition
  • Refrain from paying dividends, repurchasing shares, borrowing further, or other specific, voluntary actions that negatively affect the company’s financial position
  • Repay the loan in full, at the lender’s request, in certain events such as changes in the borrower’s debt-to-equity ratio or interest coverage ratio

Credit insurance and credit derivatives: Lenders and bond holders may hedge their credit risk by purchasing credit insurance or credit derivatives. These contracts transfer the risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is the credit default swap.

Tightening: Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30 to net 15.

Diversification: Lenders to a small number of borrowers (or kinds of borrower) face a high degree of unsystematic credit risk, called concentration risk. Lenders reduce this risk by diversifying the borrower pool.

Deposit insurance: Many governments establish deposit insurance to guarantee bank deposits of insolvent banks. Such protection discourages consumers from withdrawing money when a bank is becoming insolvent, to avoid a bank run, and encourages consumers to hold their savings in the banking system instead of in cash.