Credit risk refers to the risk that a borrower will default on any type of debt by failing
to make required payments. The risk is primarily that of the lender and includes lost principal
and interest, disruption to cash flows, and increased collection costs. The loss may be
complete or partial and can arise in a number of circumstances. For example:
A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit,
or other loan A company is unable to repay asset-secured
fixed or floating charge debt A business or consumer does not pay a trade
invoice when due A business does not pay an employee's earned
wages when due A business or government bond issuer does
not make a payment on a coupon or principal payment when due
An insolvent insurance company does not pay a policy obligation
An insolvent bank won't return funds to a depositor
A government grants bankruptcy protection to an insolvent consumer or business
To reduce the lender's credit risk, the lender may perform a credit check on the prospective
borrower, may require the borrower to take out appropriate insurance, such as mortgage
insurance or seek security or guarantees of third parties. In general, the higher the
risk, the higher will be the interest rate that the debtor will be asked to pay on the
debt.
Types of credit risk Credit risk can be classified as follows:
Credit default risk — The risk of loss arising from a debtor being unlikely to pay its loan
obligations in full or the debtor is more than 90 days past due on any material credit
obligation; default risk may impact all credit-sensitive transactions, including loans, securities
and derivatives. Concentration risk — The risk associated
with any single exposure or group of exposures with the potential to produce large enough
losses to threaten a bank's core operations. It may arise in the form of single name concentration
or industry concentration. Country risk — The risk of loss arising
from a sovereign state freezing foreign currency payments or when it defaults on its obligations;
this type of risk is prominently associated with the country's macroeconomic performance
and its political stability. Assessing credit risk
Significant resources and sophisticated programs are used to analyze and manage risk. Some
companies run a credit risk department whose job is to assess the financial health of their
customers, and extend credit accordingly. They may use in house programs to advise on
avoiding, reducing and transferring risk. They also use third party provided intelligence.
Companies like Standard & Poor's, Moody's, Fitch Ratings, Dun and Bradstreet, Bureau
van Dijk and Rapid Ratings International provide such information for a fee.
Most lenders employ their own models to rank potential and existing customers according
to risk, and then apply appropriate strategies. With products such as unsecured personal loans
or mortgages, lenders charge a higher price for higher risk customers and vice versa.
With revolving products such as credit cards and overdrafts, risk is controlled through
the setting of credit limits. Some products also require collateral,
Credit scoring models also form part of the framework used by banks or lending institutions
to grant credit to clients. For corporate and commercial borrowers, these models generally
have qualitative and quantitative sections outlining various aspects of the risk including,
but not limited to, operating experience, management expertise, asset quality, and leverage
and liquidity ratios, respectively. Once this information has been fully reviewed by credit
officers and credit committees, the lender provides the funds subject to the terms and
conditions presented within the contract. Sovereign risk
Sovereign risk is the risk of a government being unwilling or unable to meet its loan
obligations, or reneging on loans it guarantees. Many countries have faced sovereign risk in
the late-2000s global recession. The existence of such risk means that creditors should take
a two-stage decision process when deciding to lend to a firm based in a foreign country.
Firstly one should consider the sovereign risk quality of the country and then consider
the firm's credit quality. Five macroeconomic variables that affect the
probability of sovereign debt rescheduling are:
Debt service ratio Import ratio
Investment ratio Variance of export revenue
Domestic money supply growth The probability of rescheduling is an increasing
function of debt service ratio, import ratio, variance of export revenue and domestic money
supply growth. The likelihood of rescheduling is a decreasing function of investment ratio
due to future economic productivity gains. Debt rescheduling likelihood can increase
if the investment ratio rises as the foreign country could become less dependent on its
external creditors and so be less concerned about receiving credit from these countries/investors.
Counterparty risk A counterparty risk, also known as a default
risk, is a risk that a counterparty will not pay as obligated on a bond, credit derivative,
trade credit insurance or payment protection insurance contract, or other trade or transaction.
Financial institutions may hedge or take out credit insurance. Offsetting counterparty
risk is not always possible, e.g. because of temporary liquidity issues or longer term
systemic reasons. Counterparty risk increases due to positively
correlated risk factors. Accounting for correlation between portfolio risk factors and counterparty
default in risk management methodology is not trivial.
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.
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 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 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 in the event of insolvency and encourage consumers
to hold their savings in the banking system instead of in cash.
Credit risk related acronyms ACPM Active credit portfolio management
CCR Counterparty Credit Risk CVA Credit valuation adjustment
EAD Exposure at default EL Expected loss
LGD Loss given default PD Probability of default
KMV quantitative credit analysis VAR Value at Risk
PFE Potential future exposure See also
Credit Default
Further reading Bluhm, Christian, Ludger Overbeck, and Christoph
Wagner. An Introduction to Credit Risk Modeling. Chapman & Hall/CRC. ISBN 978-1-58488-326-5.
Damiano Brigo and Massimo Masetti. Risk Neutral Pricing of Counterparty Risk, in: Pykhtin,
M., Counterparty Credit Risk Modeling: Risk Management, Pricing and Regulation. Risk Books.
ISBN 1-904339-76-X. de Servigny, Arnaud and Olivier Renault. The
Standard & Poor's Guide to Measuring and Managing Credit Risk. McGraw-Hill. ISBN 978-0-07-141755-6.
Darrell Duffie and Kenneth J. Singleton. Credit Risk: Pricing, Measurement, and Management.
Princeton University Press. ISBN 978-0-691-09046-7. Principles for the management of credit risk
from the Bank for International Settlements References
External links Bank Management and Control, Springer - Management
for Professionals, 2014 Credit Risk Calculators - QuantCalc
A Guide to Modeling Counterparty Credit Risk - SSRN Research Paper, July 2007
Defaultrisk.com - research and white papers on credit risk modelling