A credit risk is risk of
default
Default may refer to:
Law
* Default (law), the failure to do something required by law
** Default (finance), failure to satisfy the terms of a loan obligation or failure to pay back a loan
** Default judgment, a binding judgment in favor of ei ...
on a debt that may arise from a borrower failing to make required payments.
In the first resort, the risk is that of the lender and includes lost
principal and
interest
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is disti ...
, disruption to
cash flow
A cash flow is a real or virtual movement of money:
*a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are expected ...
s, and increased
collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as
yield spreads can be used to infer credit risk levels based on assessments by market participants.
Losses can arise in a number of circumstances, for example:
* A consumer may fail to make a payment due on a
mortgage loan
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any p ...
,
credit card
A credit card is a payment card issued to users (cardholders) to enable the cardholder to pay a merchant for goods and services based on the cardholder's accrued debt (i.e., promise to the card issuer to pay them for the amounts plus the o ...
,
line of credit
A line of credit is a credit facility extended by a bank or other financial institution to a government, business or individual customer that enables the customer to draw on the facility when the customer needs funds. A line of credit takes se ...
, 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
wage
A wage is payment made by an employer to an employee for work done in a specific period of time. Some examples of wage payments include compensatory payments such as ''minimum wage'', '' prevailing wage'', and ''yearly bonuses,'' and remun ...
s when due.
* A business or government
bond issuer does not make a payment on a
coupon
In marketing, a coupon is a ticket or document that can be redeemed for a financial discount or rebate when purchasing a product.
Customarily, coupons are issued by manufacturers of consumer packaged goods
or by retailers, to be used in re ...
or principal payment when due.
* An insolvent
insurance company
Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...
does not pay a policy obligation.
* An insolvent
bank
A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets.
Becau ...
won't return funds to a depositor.
* A government grants
bankruptcy protection to an
insolvent
In accounting, insolvency is the state of being unable to pay the debts, by a person or company (debtor), at maturity; those in a state of insolvency are said to be ''insolvent''. There are two forms: cash-flow insolvency and balance-sheet i ...
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" \n\n\nsecurity.txt is a proposed standard for websites' security information that is meant to allow security researchers to easily report security vulnerabilities. The standard prescribes a text file called \"security.txt\" in the well known locat ...
over some assets of the borrower or a
guarantee
Guarantee is a legal term more comprehensive and of higher import than either warranty or "security". It most commonly designates a private transaction by means of which one person, to obtain some trust, confidence or credit for another, engages ...
from a third party. The lender can also take out insurance against the risk or on-sell the debt to another company. In general, the higher the risk, the higher will be the
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, t ...
that the debtor will be asked to pay on the debt.
Credit risk mainly arises when borrowers are unable or unwilling to pay.
Types
A credit risk can be of the following types:
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
The derivative of a function is the rate of change of the function's output relative to its input value.
Derivative may also refer to:
In mathematics and economics
*Brzozowski derivative in the theory of formal languages
*Formal derivative, an ...
.
*
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
Country risk refers to the risk of investing or lending in a country, arising from possible changes in the business environment that may adversely affect operating profits or the value of assets in the country. For example, financial factors such ...
– The risk of loss arising from a sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (
sovereign risk); this type of risk is prominently associated with the country's macroeconomic performance and its political stability.
Assessment
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 (or not) accordingly. They may use in-house programs to advise on avoiding, reducing and transferring risk. They also use the third party provided intelligence. Companies like
Standard & Poor's
S&P Global Ratings (previously Standard & Poor's and informally known as S&P) is an American credit rating agency (CRA) and a division of S&P Global that publishes financial research and analysis on stocks, bonds, and commodities. S&P is co ...
,
Moody's
Moody's Investors Service, often referred to as Moody's, is the bond credit rating business of Moody's Corporation, representing the company's traditional line of business and its historical name. Moody's Investors Service provides internation ...
,
Fitch Ratings
Fitch Ratings Inc. is an American credit rating agency and is one of the " Big Three credit rating agencies", the other two being Moody's and Standard & Poor's. It is one of the three nationally recognized statistical rating organizations ( NRS ...
,
DBRS
DBRS Morningstar is a global credit rating agency (CRA) founded in 1976 (originally known as Dominion Bond Rating Service in Toronto). DBRS was acquired by the global financial services firm Morningstar, Inc. in 2019 for approximately $700 mil ...
,
Dun and Bradstreet
The Dun & Bradstreet Corporation is an American company that provides commercial data, analytics, and insights for businesses. Headquartered in Jacksonville, Florida, the company offers a wide range of products and services for risk and financia ...
,
Bureau van Dijk and
Rapid Ratings International provide such information for a fee.
For large companies with liquidly traded corporate bonds or Credit Default Swaps, bond yield spreads and credit default swap spreads indicate market participants assessments of credit risk and may be used as a reference point to price loans or trigger collateral calls.
Most lenders employ their models (
credit scorecards) 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, the risk is controlled through the setting of credit limits. Some products also require
collateral
Collateral may refer to:
Business and finance
* Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan
* Marketing collateral, in marketing and sales
Arts, entertainment, and media
* ''Collate ...
, usually an asset that is pledged to secure the repayment of the loan.
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 (as outlined above).
Sovereign risk
Sovereign credit 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 Great Recession was a period of marked general decline, i.e. a recession, observed in national economies globally that occurred from late 2007 into 2009. The scale and timing of the recession varied from country to country (see map). At t ...
. 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, the 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
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased c ...
or counterparty credit risk (CCR), is a risk that a
counterparty
A counterparty (sometimes contraparty) is a legal entity, unincorporated entity, or collection of entities to which an exposure of financial risk may exist. The word became widely used in the 1980s, particularly at the time of the Basel I deliberat ...
will not pay as obligated on a
bond,
derivative
In mathematics, the derivative of a function of a real variable measures the sensitivity to change of the function value (output value) with respect to a change in its argument (input value). Derivatives are a fundamental tool of calculus. ...
,
insurance policy
In insurance, the insurance policy is a contract (generally a standard form contract) between the insurer and the policyholder, which determines the claims which the insurer is legally required to pay. In exchange for an initial payment, known as ...
, or other contract.
Financial institutions or other transaction counterparties may
hedge
A hedge or hedgerow is a line of closely spaced shrubs and sometimes trees, planted and trained to form a barrier or to mark the boundary of an area, such as between neighbouring properties. Hedges that are used to separate a road from adjoin ...
or take out
credit insurance or, particularly in the context of derivatives, require the posting of collateral.
Offsetting counterparty risk is not always possible, e.g. because of temporary liquidity issues or longer-term systemic reasons.
Further, counterparty risk increases due to positively correlated risk factors;
accounting for this correlation between portfolio risk factors and counterparty default in risk management methodology is not trivial.
The
capital requirement here is calculated using SA-CCR, the
Standardized approach for counterparty credit risk.
This framework replaced both non-internal model approaches - Current Exposure Method (CEM) and Standardised Method (SM).
It is a "risk-sensitive methodology", i.e. conscious of
asset class and
hedging, that differentiates between
margined and non-margined trades and recognizes
netting benefits; issues insufficiently addressed under the preceding frameworks.
Mitigation
Lenders mitigate credit risk in a number of ways, including:
* Risk-based pricing – Lenders may charge a higher
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, t ...
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
A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaultin ...
, and
loan-to-value ratio
The loan-to-value (LTV) ratio is a financial term used by lenders to express the ratio of a loan to the value of an asset purchased.
In Real estate, the term is commonly used by banks and building societies to represent the ratio of the first ...
and estimates the effect on yield (
credit spread).
* Covenants – Lenders may write stipulations on the borrower, called
covenants, into loan agreements, such as:
** Periodically report its financial condition,
** Refrain from paying
dividend
A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-inv ...
s,
repurchasing shares, borrowing further, or other specific, voluntary actions that negatively affect the company's financial position, and
** 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
A hedge or hedgerow is a line of closely spaced shrubs and sometimes trees, planted and trained to form a barrier or to mark the boundary of an area, such as between neighbouring properties. Hedges that are used to separate a road from adjoin ...
their credit risk by purchasing credit insurance or
credit derivatives. These contracts transfer the risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is the
credit default swap
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against som ...
.
* Tightening – Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a
distributor
A distributor is an enclosed rotating switch used in spark-ignition internal combustion engines that have mechanically timed ignition. The distributor's main function is to route high voltage current from the ignition coil to the spark p ...
selling its products to a troubled
retailer
Retail is the sale of goods and services to consumers, in contrast to wholesaling, which is sale to business or institutional customers. A retailer purchases goods in large quantities from manufacturers, directly or through a wholesaler, an ...
may attempt to lessen credit risk by reducing payment terms from ''net 30 '' to ''net 15''.
* Diversification – Lenders to a small number of borrowers (or kinds of borrower) face a high degree of
unsystematic credit risk, called
concentration risk.
MBA Mondays:Risk Diversification
/ref> Lenders reduce this risk by diversifying the borrower pool.
* Deposit insurance – Governments may establish deposit insurance
Deposit insurance or deposit protection is a measure implemented in many countries to protect bank depositors, in full or in part, from losses caused by a bank's inability to pay its debts when due. Deposit insurance systems are one component of a ...
to guarantee bank deposits in the event of insolvency and to encourage consumers to hold their savings in the banking system instead of in cash.
Related acronyms
* ACPM Active credit portfolio management
* CCR Counterparty Credit Risk
* CE Credit Exposure
* CVA Credit valuation adjustment
* DVA Debit Valuation Adjustment – see XVA
* EAD Exposure at default
* EE Expected Exposure
* EL Expected loss Expected loss is the sum of the values of all possible losses, each multiplied by the probability of that loss occurring.
In bank lending (homes, autos, credit cards, commercial lending, etc.) the expected loss on a loan varies over time for a nu ...
* LGD Loss given default
* PD Probability of default
* PFE Potential future exposure
* SA-CCR The Standardised Approach to Counterparty Credit Risk
* VAR Value at risk
Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day. VaR is typically used by ...
See also
* Credit (finance)
Credit (from Latin verb ''credit'', meaning "one believes") is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a ...
* Default (finance)
In finance, default is failure to meet the legal obligations (or conditions) of a loan, for example when a home buyer fails to make a mortgage payment, or when a corporation or government fails to pay a bond which has reached maturity. A na ...
* Distressed securities
* Jarrow–Turnbull model
* Merton model The Merton model,
developed by Robert C. Merton in 1974, is a widely used credit risk model.
Analysts and investors utilize the Merton model to understand how capable a company is at meeting financial obligations, servicing its debt, and weighing ...
* Criticism of credit scoring systems in the United States
References
Further reading
*
*
*
*
*
Principles for the management of credit risk
from the Bank for International Settlements
External links
Bank Management and Control
Springer Nature – Management for Professionals, 2020
Credit Risk Modelling
- information on credit risk modelling and decision analytics
A Guide to Modeling Counterparty Credit Risk
– SSRN Research Paper, July 2007
Defaultrisk.com
– research and white papers on credit risk modelling
The Journal of Credit Risk
publishes research on credit risk theory and practice.
Soft Data Modeling Via Type 2 Fuzzy Distributions for Corporate Credit Risk Assessment in Commercial Banking
SSRN Research Paper, July 2018
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