What does credit risk assess?

Credit risk specifically assesses the likelihood of a borrower defaulting on their obligations, such as failing to make scheduled loan payments. This evaluation involves analyzing various factors, including the creditworthiness of the borrower, their credit history, income levels, and overall financial situation. The objective is to determine the risk involved in lending to a particular individual or entity, which helps lenders make informed decisions about extending credit and setting appropriate interest rates or terms.

Understanding credit risk is crucial for financial institutions since a higher likelihood of default can lead to significant losses. Institutions often use credit scoring models and comprehensive risk assessments to quantify this risk, which in turn influences their lending strategies and policies. By effectively assessing credit risk, lenders can minimize potential losses and ensure the sustainability of their loan portfolios.