How to calculate credit risk cost in an SME loan portfolio

Credit risk management is a fundamental pillar for the financial stability of any entity that grants loans, especially in the small and medium-sized enterprises (SMEs) segment. Understanding how risk cost is calculated allows financial directors and risk managers to adjust margins, optimize capital, and meet regulatory requirements without sacrificing competitiveness. Below, the essential components of this calculation and their impact on net profitability are broken down.

The fundamental formula: Expected Loss

The calculation of credit risk is based on determining the expected loss (EL). The standard formula used in the financial industry is:

EL = PD × EAD × LGD

Where each variable represents a critical component of risk:

• Probability of Default (PD): This is the probability that a debtor will fail to meet their payment obligations. In the context of SMEs, this metric depends not only on payment history but also on financial viability, current repayment capacity, and fluctuations in their economic activity.
• Exposure at Default (EAD): This represents the value of the position or the outstanding amount in the portfolio at the time the default occurs. For products such as credit lines, EAD must consider not only the current balance but also the potential utilization of undrawn credit.
• Loss Given Default (LGD): This indicates the portion of the exposure that will not be recoverable after a default. It is calculated based on the recovery rate (R), meaning LGD = 1 - R. This variable is influenced by the existence and quality of collateral guarantees, as well as the liquidity risk of said guarantees.

The IFRS 9 regulatory framework and the forward-looking approach

Since the entry into force of the international accounting standard IFRS 9 in 2018, the calculation of provisions has changed radically. Unlike previous regulations, which required provisioning only when the credit was already classified as doubtful (incurred loss approach), IFRS 9 adopts a forward-looking approach based on expected loss.

This change implies that entities must set provisions anticipating the deterioration of the portfolio, taking into account:

1. Macroeconomic outlooks: The future economic environment directly affects customers' repayment capacity.
2. Portfolio knowledge: Detailed information about customers and their historical behavior.
3. Risk stages: The standard classifies financial instruments into three categories according to the evolution of their credit risk:
   • Stage 1: Performing transactions with no signs of deterioration. Most loans remain in this category throughout their useful life.
   • Stage 2: Performing transactions with a significant increase in credit risk or early warning alerts.
   • Stage 3: Doubtful transactions, either due to actual default or subjective delinquency (customers who are up to date on payments but have a high probability of default).

Key metrics for assessing credit quality

To measure the credit quality of an entity and its impact on profitability, it is necessary to jointly analyze three main metrics. The isolated analysis of a single indicator can lead to erroneous conclusions.

1. Delinquency ratio

This is the relationship between the volume of doubtful credit and the total credit portfolio, expressed as a percentage. Doubtful credits are considered not only unpaid balances (more than 90 days) but also those that are up to date on payments but have a high probability of default due to factors such as belonging to vulnerable sectors or problematic refinancings. The latter concept is known as subjective delinquency or unlikely to pay credits.

2. Coverage ratio

This measures the relationship between the accumulated provision fund on the balance sheet and the volume of doubtful credit. It indicates what percentage of doubtful credits is provisioned. It is important to note that the direct comparison of this ratio between banks is limited, as it depends on the composition of the portfolio. For example, a bank with more mortgages (collateralized) may have a lower coverage ratio than one with more unsecured business loans, without this implying less protection against future deteriorations.

3. Risk cost

This is the relationship between the provisions set in a given period (annualized) and the average volume of the credit portfolio. It is usually expressed in basis points (100 basis points equal 1%).

Risk cost measures the effort an entity makes to protect itself against estimated future losses. Under the IFRS 9 framework, this cost can peak before the delinquency ratio, as provisions are set progressively according to the customer's risk profile, anticipating deterioration.

Impact on net profitability

Risk cost, along with the coverage ratio and the delinquency ratio, directly affects the net profitability of the entity. A high risk cost reduces the profit margin, while efficient risk management allows maintaining competitive margins without assuming excessive risks.

Understanding these components allows companies and financial entities to:

• Optimize capital management: Allocate resources more efficiently according to the risk profile of each customer.
• Adjust margins: Establish interest rates that adequately compensate for the risk assumed.
• Meet regulatory requirements: Ensure compliance with accounting and solvency standards.

Credit risk management and mitigation

To minimize the impact of credit risk, it is fundamental to analyze the financial viability and repayment capacity of customers. This includes:

• Verifying that customer documentation is in order.
• Evaluating repayment capacity through their liquid assets.
• Considering the fluctuation of their economic activity.

Additionally, the purchase of credit insurance can be an effective tool to cover losses arising from default, especially in commercial transactions with deferred payment. These insurances cover both commercial risks (insolvency, non-payment) and political risks (in international operations), allowing companies to focus on their main activity.

In conclusion, the calculation of credit risk cost is not only an accounting obligation but a strategic tool for financial decision-making. The integration of forward-looking data and the joint analysis of key metrics allow financial entities to navigate uncertain economic environments with greater security.