Credit Risk

We’ve compiled a list of the most common and frequently asked interview questions on credit risk. These questions will help you to clear any finance job interview.

Q.1 What do you know about credit risk?

This is a chance to really impress the interviewer with your knowledge and understanding of the sector. You are required to demonstrate that you have done your research well and helps to demonstrate your skills and functionalities of the domain. It is suggested to perform your research beforehand and brush up on credit risk knowledge. You are suggested to demonstrate the role of credit risk analyst entails and skills possessed to perform the tasks.

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Q.2 Why credit risk interests you?

It is suggested that you should demonstrate to the interviewer that you are passionate and keen about credit risk sector. You must specify the elements of the job that you find particularly interesting and why credit risk motivates you. Do not forget to link your interest back to your own skills and experiences, as interviewers prefer specific examples.

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Q.3 What are the types of Credit Facilities available for an organization?

There are 2 types of credit facilities available in an organization -

1. Short term loans -They are primarily for working capital needs. Examples - overdraft, letter of credit, factoring, export credit and more.

2. Long-term loans - They are required for capital expenditure or acquisition. Examples - bank loans, notes, mezzanine loans, securitization and bridge loans.

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Q.4 What is a Credit Default Swap?

A credit default swap (CDS) is one of the most5 used methods of mitigating risk in fixed-income, debt security instruments like bonds, and is considered as the most common financial derivatives. credit default swap (CDS) is essentially a type of investment insurance that allows the buyer to mitigate his investment risk by shifting risk to the seller of a CDS in exchange for a fee and the seller of the CDS stands in the position of guaranteeing the debt security in which the buyer has invested.

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Q.5 What is the reason for high profiting sales to mitigate credit risk?

It is observed that high profit sales reduce credit risk by providing a greater profit incentive in case the borrower is unable to pay the debt. Credit risk is concerned with the likelihood that the borrower is not financially able to pay the debt. The less likely the debt may be paid, the higher the credit risk. This is related to the risk-return trade-off.

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Q.6 What does a 'Z score refers to?

Z score refers to a Predictive coefficient of Corporate failure developed by Edward Altman

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Q.7 What does the going concern concept refers to?

Going concern concept refers to an assumption that a company will continue in business for the foreseeable future.

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Q.8 Which financial statement shows source and application of funds

Cash flow shows source and application of funds.

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Q.9 What is the aim of performing risk analysis?

The aim of performing risk analysis is to best obtain collateral and security for the credit.

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Q.10 What does trade debtors refer to?

It refers to debts owed to the company by customers of the company on credit terms

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Q.11 What do you mean by Credit Risk?

Credit risk is the possibility for a loss to occur due to the failure of a borrower to meet its contractual obligation to repay a debt. For example, a homeowner may stop making mortgage payments. This is also called ‘default risk’ or ‘counter-party risk’, and pertinent credit events may include bankruptcy, failure to pay, loan restructuring, loan moratorium, or accelerated loan payments.

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Q.12 What is Operational Risk?

Operational Risk is the loss occurred due to a business’ operations i.e. process, human resources, systems, external events. It also comes about through external events such as political, legal, and fraud risks.

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Q.13 Define Market Risk?

Market risk is the Risk caused by unexpected changes in market factors such as interest rates, stock prices, commodity prices, and foreign exchange rates

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Q.14 How is Credit Risk measured and on what does it depend upon?

Credit risk exposure is measured by the current mark to market value. The magnitude of credit risk depends on the likelihood of default by the counter party the potential value of outstanding contracts the extent to which legally enforceable netting arrangements allow the value of offsetting contracts the value of the collateral held against the contracts

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Q.15 What is a Collateral?

Collateral represents a repayment source in the worst-case scenario. Most banks require that the loan be 100 per cent collateralized. This means that the business has to have enough collateral to cover 100 per cent of the loan amount. For example, if a loan for Rs.50 lacs is needed, then a car, equipment, building, and inventory must to possessed that add up to Rs. 50 lacs.

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Q.16 What is the most common risk Metric In Loans?

Most common risk metric is the adequacy of loan loss provisions and the size of the loan loss reserve in relationship to the total exposures of the bank. Allowance for loan losses creates a cushion of credit losses in the bank’s credit portfolio. Primarily it is intended to absorb the bank’s expected loan losses. Historically credit decisions were made in a case by case basis.

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Q.17 What is a credit default swap?

A credit default swap (CDS) is a frequently used method of mitigating risk in fixed-income, debt security instruments such as bonds, and it is one of the most common financial derivatives. It is essentially a type of investment insurance that allows the buyer to mitigate his investment risk by shifting risk to the seller of a CDS in exchange for a fee. The seller of the CDS stands in the position of guaranteeing the debt security in which the buyer has invested.

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Q.18 How do we perform risk identification?

Risk identification is a preliminary step in risk management that involves Communicating and documenting concerns. Risk identification begins with understanding business objectives. A Risk manager must identify undesirable outcomes, unwanted events, emerging opportunities as well as emerging threats.

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Q.19 What are the different categories of Risks?

 Typically banks distinguish the following risk categories: credit risk, market risk, operational risk. There are further types of risks, such as strategic risks, or reputational risks, which cannot usually be included in risk measurement for lack of consistent methods of quantification.

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Q.20 How are expected losses derived?

Unexpected Losses are derived from the borrower’s expected probability of default and the predicted exposure at default less the recovery rate, i.e. all expected cash flows, especially from the realization of collateral. The expected losses should be accounted for in income planning and included as standard risk costs in the credit conditions.

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Q.21 What can unexpected Losses lead to?

These losses result from deviations in losses from the expected loss. Unexpected losses are taken into account only indirectly via equity cost in the course of income planning and setting of credit conditions. They have to be secured by the risk coverage capital.

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Q.22 What should you keep in mind while aggregating Risks?

When aggregating risks, it is important to take into account correlation effects which cause a company’s overall risk to differ from the sum of the individual risks. This applies to risks both within a risk category as well as across different risk categories.

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Q.23 Name some tools for managing Risks.

The most commonly utilized tools for managing risk are: risk-adjusted pricing of individual loan transactions setting of risk limits for individual positions or portfolios use of guarantees, derivatives, and credit insurance securitization of risks buying and selling of assets

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Q.24 Why should we monitor risks?

Monitoring of risk is used to study whether the risks that truly incurred lie within the prescribed range, thus ensuring an institution’s capacity to endure these risks. Going further, the effectiveness of the measures implemented in risk controlling is measured, and new impulses are generated if necessary.

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Q.25 Name some common faults experienced in credit risk management.

The common faults experienced in credit risk management are, Absence of written policies Absence of portfolio concentration limits Poor industry analysis Inadequate financial analysis of borrowers Credit rationing contributing to deterioration of loan quality Excessive reliance on collateral

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Q.26 How often does the company refresh its assessment of the top risks?

The enterprise-wide risk assessment process should be responsive to change in the business environment. A robust process for identifying and prioritizing the critical enterprise risks, including emerging risks, is vital to an evergreen view of the top risks.

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Q.27 How are rows structured in risk assessment matrix?

In a risk assessment matrix, rows can be structured as follows: Catastrophic: Devastating impact on financial standing, business operations or people in the workplace. Critical: Major impact on financial standing, business operations or people in the workplace. Moderate: Very noticeable impact on financial standing, business operations or people in the workplace. Minor: Some impact on financial standing, business operations or people in the workplace. Insignificant: Little to no impact on financial standing, business operations or people in the workplace.

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Q.28 what Is a Good Debt-to-Equity Ratio?

Debt-to-equity (D/E) ratio is a key, if not the primary, financial ratio considered in evaluating a company's ability to handle its debt financing obligations. The D/E ratio indicates a company’s total debt in relation to its total equity, and it reveals what percentage of a company's financing is being provided by debt and what percentage by equity.

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Q.29 What is Inflation?

Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.

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Q.30 How are lending limits set?

A system of credit limits, restricts losses to a level which does not compromise a company’s solvency. Lending limits have to be set taking into account capital and resources. Any limit on credit has to be accompanied by a general limit on all risk assets. This would enable the business to hold a minimum proportion of assets such as cash and government securities whose risk of default is zero.

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Q.31 What do you mean by diversification?

Diversification involves the spread of lending over different types of borrowers, different economic sectors and different geographical regions. To a certain extent credit limits which help avoid concentration of lending ensures minimum diversification. The spread of lending is likely to reduce serious credit problems. Size however confers an advantage in diversification because large businesses can diversify by industry as well as region.

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Q.32 How can companies reduce Credit Risk?

Companies can reduce credit risk by, Raising credit standards to reject risky loans Obtain collateral and guarantees Ensure compliance with loan agreement Transfer credit risk by selling standardized loans

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Q.33 What is a pledge?

A ‘pledge’ is mortgage of a movable property which requires delivery of possession

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Q.34 Define balance sheet?

The balance sheet or net worth statement is a snapshot of the financial position of a business on a specific date. It shows the value of all assets which is “balanced” between the value of all liabilities or the claims of others against the business and the net worth or the owner’s claims against the business.

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Q.35 What is an Income Statement?

The income statement, or profit and loss (P&L) statement, shows the net income for the business during the accounting period. It includes income generated, the operating and overhead costs, depreciation on assets, gains or losses on disposal of capital assets and income and expenses. It can be prepared on a cash or accrual basis. 

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Q.36 What is the purpose of a Cash flow Statement?

The cash flow statement can be a statement of past activities or a budget of expected cash inflows and outflows. It shows a complete accounting of debt transactions including principal and interest payments as well as the proceeds from new loans.

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Q.37 What are the items that are included in cash flow statement but not in income flow statement?

 Items included in a complete cash flow but not in an income statement include family living costs, income and expenses, and income taxes.

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Q.38 What do you mean by Liquidity?

 Liquidity is the ability of a business to meet financial obligations as they come due without disrupting the normal operations of the business including paying living expenses, taxes and debt payments.

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Q.39 What does ROE Indicate?

Return on Equity (ROE) indicates the rate of return on equity capital and is particularly on equity capital significant in the context of objective of maximization of share value. Equity is the sum of share capital, preferred shares, paid-in surplus, retained earnings and reserves for future contingencies.

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Q.40 What does Modern Finance theory Imply?

Modern finance theory implies that declining credit may not necessarily be the proper response to low credit quality. The view of modern theory about risk postulate is that the necessary return should be adjusted for the risk taken. If the risk has been correctly calculated then, losses will be compensated by gains elsewhere.

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Q.41 What are Statistical Models?

Statistical models are considered to be more systemic in approach, eg credit scoring models. The results of this analysis is then used in the decision space, namely to reach a decision whether to grant, or not grant, credit.

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Q.42 What are the two types of assessments?

The two types of assessments are qualitative assessments and quantitative assessments. These are then often used together to produce an accurate credit assessment, where the two are usually carried out in parallel. Insights obtained from one aspect of the investigation leads to investigation in the other. While the various approaches are used to assess credit quality, they are often used as a combination in the decision-making process.

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Q.43 what is the Value-at-Risk Concept?

VaR lets an investor know in monetary terms how much one’s portfolio can expect to lose, for a given cumulative probability and for a given time horizon. To calculate the credit VaR, it is necessary to determine the distribution of potential losses in the credit portfolio. For this purpose, assumptions are made in terms of the future development of the default rate and the exposure at default.

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Q.44 What are the limitations of VaR?

The value-at-risk analysis has limited descriptive ability. Even though it showcases the figure of losses within the confidence level chosen, it does not indicate any prediction about the probability distribution of losses beyond that confidence level. Going further, the VaR misses to take into account any extreme events in an economic crisis with extremely high default rates. The VaR relies on certain assumptions and estimates which can lead to misinterpretations of the risk. There are constraints to the comparability and aggregation of different types of risks caused by the different distribution of the risk types.

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Q.45 What is Free Cash Flow?

Free cash flow is simply equal to cash from operations minus capital expenditures (levered free cash flow). Unlevered free cash flow is used in financial modeling.

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Q.46 What is the interest coverage ratio?

This is commonly calculated as EBIT divided by interest expense. It is also referred to as the “times interest earned” ratio. The interest coverage ratio indicates how easily a company can “cover” it’s interest expense with operating earnings before interest and taxes are subtracted.

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Q.47 What is Loss given default (LGD)?

The LGD is the ratio of the loss on an exposure caused by the default of the counterparty to the amount outstanding at default. This ratio is calculated by businesses following the Internal Ratings-Based Approach (IRBA) for their retail portfolios. The estimated LGDs are necessary for the capital requirement of the institute because of incurred credit risk. The pricing process of credits is also highly affected by an accurate estimation of possible losses.

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Q.48 Describe the meaning of a risk breakdown structure

A risk breakdown structure or RBS is a representation of risks in a hierarchical manner. An RBS begins with the risks at higher levels and goes down to the risks at the finest level. With different levels, it is easier to streamline risks. Besides, it makes it quicker to identify risks categorically with focus being accorded to specific risk categories

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Q.49 What are technology Risks?

 Some projects require the use of the latest technology. Some organizations may not manage to acquire the latest technology, hence making that a risk factor.

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Q.50 What do you mean by Risk Probability?

Risk probability refers to the possibility of having a risk event. This possibility can be represented in a quantitative and qualitative manner. Risk probability is expressed qualitatively using terms such as rare, possible, and frequent. Numerical expression utilizes frequencies, percentages, and scores.

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Q.51 what do you mean by exposure at default (EAD)?

The exposure at default (EAD) pertains to the amount owed to the business. Therefore, apart from the type of claim, the amount of the claim is also a significant variable in the credit approval process.

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Q.52 What factors are considered in segmentation of credit approval process?

Four factors are considered in the segmentation of credit approval processes: type of borrower source of cash flows value and type of collateral amount and type of claim

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Q.53 What does Rating Outlook indicate?

Rating outlook indicates the medium-term potential evolution of the rating in the future. A favourable or unfavourable outlook means that the rating may be increased or decreased. A rating with a stable outlook will most likely not be changed. A developing rating outlook indicates that the rating may be lowered or raised. Credit watch lists are used to determine shorter-term change. This means that the rating is put on the watch list when an event deviates from the expected trend and there is a good probability of a change in the rating.

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Q.54 What are solicited ratings?

‘Solicited ratings’ are ratings that are initiated and paid for by the issuer. Occasionally, issuers may not opt to be rated as they rarely raise debt or equity in international financial markets. Another reason is if the issuer is apprehensive about getting a negative rating that may limit his/her future access to funds.

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Q.55 What are the reasons for Split ratings?

Reasons for split ratings are, different rating methodologies, access to different information, use of different rating scales, sample selection bias.

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Q.56 What are Securities?

Securities help to defend an entity from possible credit loss situation. There are a number of tools or ‘securities’ that an individual or firm can use to best guard themselves in uncertain times. These may be in the form of stocks, property, gold etc. Security assures the lender that the borrower has a stake, equity, or risk capital to fall back on in the event of a default.

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Q.57 Define Stocks and Shares with respect to securities.

Stocks and shares are highly liquid, and therefore they are quite often considered as securities. If the stock is chosen correctly with strength and stability in its value, the returns will also be promising and quickly realizable. On the other hand, share market instruments are quite often susceptible to external events (political, legal etc.) and therefore highly risky.

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Q.58 What are Bonds?

Bonds are a type of debt security. When a government, corporation or other entity needs to raise funds, they can borrow money from investors by issuing bonds to them. Investors who purchase a bond from an issuer are in essence lending money to the issuer for a fixed period of time. In return, investors receive a bond promising that they will receive interest payments at certain times and also have their principal returned on a stated future date.

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Q.59 What is the Standardised Approach?

The standardized approach is a further sophistication of the Basel I Capital Accord with a more specific classification of the credit risk. The measurement of the credit quality is determined by an External Credit Assessment Institution (ECAI).

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Q.60 Why do Businesses need working Capital?

All business needs working capital to: adequate supply of raw materials for processing; cash to pay for wages, power and other costs; creating a stock of finished goods to feed the market demand regularly; and, the ability to grant credit to its customers.

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