As part of my preparations for exam, I recently came across this line “Credit risk and default risk can be used interchangeably”. This actually made me wonder on whether it is actually true. This blog post will try to analyse on how the two are same or different.
I have little doubt that credit risk and default risk are directly linked to one another as higher the credit risk, higher the chance of default. Now if we look at the reverse of this argument, higher the default risk, higher should be the credit risk as well. But the reverse is not necessarily true. If higher default risk is always related with higher credit risk, then no default would have occurred in the first place. Why? Because such loans would not have been approved in the first place due to poor credit rating.
This brings us to another question: How then should we determine the default risk with respect to credit risk ? The key to such scenarios lies in understanding the willingness of the borrower to pay much more than his ability to pay. The moral compass of the borrower plays a much bigger role in determining whether the creditor will suffer a default risk.
A prime example of this can be the case of liquor baron, Vijay Mallya. He did not lack the funds to make the repayment, but felt that there is no need to, basically a wilful defaulter. An estimate of the Indian Banking scenario highlights as much as INR 3.8 lac crores of bad debt in the present scenario. Clearly there should be better metrics to identify wilful defaulters in the modern era.
Historical data is one way to identify such issues, however it may or may not be relevant in the present scenario. What other metrics can be used to measure and identify such wilful defaulters? I will try to post more in this regard in upcoming posts.
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