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A credit risk is risk of
default Default may refer to: Law * Default (law), the failure to do something required by law ** Default (finance) In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It ...
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 Principal may refer to: Title or rank * Principal (academia) The principal is the chief executive and the chief academic officer of a university A university ( la, universitas, 'a whole') is an educational institution, institution of higher ...
and
interest In and , interest is payment from a or deposit-taking financial institution to a or depositor of an amount above repayment of the (that is, the amount borrowed), at a particular rate. It is distinct from a which the borrower may pay the len ...

interest
, disruption to
cash flow A cash flow is a real or virtual movement of money Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in ...
s, and increased
collection costA collection cost is the cost incurred to collect debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which ...
s. 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 spread Yield may refer to: Measures of output/function Computer science * Yield (multithreading) is an action that occurs in a computer program during multithreading * See generator (computer programming) Physics/chemistry * Yield (chemistry) In ch ...
s 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 () 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 purpose while putting a lien on the property being mortgaged. T ...
,
credit card #REDIRECT 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 promise to the card issuer to pay them for the amounts plus the ...

credit card
,
line of credit A line of credit is a credit px, Domestic credit to private sector in 2005 Credit (from Latin Latin (, or , ) is a classical language belonging to the Italic languages, Italic branch of the Indo-European languages. Latin was originally s ...
, or other loan. * A
company A company, abbreviated as co., is a Legal personality, legal entity representing an association of people, whether Natural person, natural, Legal person, legal or a mixture of both, with a specific objective. Company members share a common pu ...

company
is unable to repay asset-secured fixed or
floating charge A floating charge is a security interest A security interest is a legal right granted by a debtor to a creditor over the debtor's property (usually referred to as the '' collateral'') which enables the creditor to have recourse to the property if ...
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 the distribution from an employer of a ''security'' (expected return or profits derived solely from others) paid to an employee. Like interest is paid out to an investor on his investments, a wage is paid (from company earnings) to t ...

wage
s when due. * A business or government
bond Bond or bonds may refer to: Common meanings * Bond (finance) In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of ...
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 discounts and allowances, discount or rebate (marketing), rebate when purchasing a product (business), product. Customarily, coupons are issued by manufacturers ...
or principal payment when due. * An insolvent
insurance company Insurance is a means of protection from financial loss. It is a form of risk management, primarily used to Hedge (finance), hedge against the risk of a contingent or uncertain loss. An entity which provides insurance is known as an insurer, ...
does not pay a policy obligation. * An insolvent
bank A bank is a financial institution Financial institutions, otherwise known as banking institutions, are corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), stat ...

bank
won't return funds to a depositor. * A government grants
bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditor A creditor or lender is a party 300px, '' Hip, Hip, Hurrah!'' (1888) by Peder Severin Krøyer, a painting portraying an artists' par ...

bankruptcy
protection to an
insolventInsolvency 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 insolvency. Cash-flow i ...
consumer or business. To reduce the lender's credit risk, the lender may perform a
credit check A credit score is a numerical expression based on a level analysis of a person's credit files, to represent the creditworthiness A credit risk is risk of default Default may refer to: Law * Default (law), the failure to do something requ ...
on the prospective borrower, may require the borrower to take out appropriate insurance, such as
mortgage insurance Mortgage insurance (also known as mortgage guarantee and home-loan insurance) is an insurance policy which compensates lenders or investors in Mortgage-backed security, mortgage-backed securities for losses due to the Default (finance), default of ...
, or seek
security Security is freedom from, or resilience against, potential Potential generally refers to a currently unrealized ability. The term is used in a wide variety of fields, from physics Physics is the natural science that studies matter, its El ...
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 In and , interest is payment from a or deposit-taking financial institution to a or depositor of an amount above repayment of the (that is, the amount borrowed), at a particular rate. It is disti ...
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 Derivative may refer to: In mathematics and economics *Brzozowski derivative in the theory of formal languages *Derivative in calculus, a quantity indicating how a function changes when the values of its inputs change. *Formal derivative, an opera ...
. *
Concentration risk Concentration risk is a bank A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank o ...
– 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 A country is a distinct territorial body or political entity A polity is an identifiable political entity—any group of people who have a collective identity, who are organized by some form of Institutionalisation, institutionalized social ...
– 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 Sovereign is a title which can be applied to the highest leader in various categories. The word is borrowed from Old French Old French (, , ; French language, Modern French: ) was the language spoken in Northern France from the 8th century to t ...
); 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 A credit rating agency (CRA, also called a ratings service) is a company that assigns credit ratings, which rate a debtor's abilit ...

Standard & Poor's
,
Moody's Moody's Investors Service, often referred to as Moody's, is the bond credit rating In investment To invest is to allocate money Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed to Kin ...
,
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 Moody's Investors Service, often referred to as Moody's, is the bond credit rating business of Moody's Corp ...
,
DBRS DBRS Morningstar is a global credit rating agency (CRA) founded in 1976 (originally known as Dominion Bond Rating Service in Toronto Toronto is the capital city of the Provinces and territories of Canada, Canadian province of Ontario. With ...
,
Dun and Bradstreet The Dun & Bradstreet Corporation is an American company that provides commercial data, analytics, and insights for businesses. It is headquartered in Short Hills, a community in Millburn, New Jersey. The company offers a wide range of products ...
,
Bureau van Dijk Bureau van Dijk is a major publisher of business informationBusiness information is one of the three main segments of the information industry. The other two segments are ''scientific, technical and medical (STM)'' and ''educational and traini ...
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 scorecardsCredit scorecards are mathematical models which attempt to provide a quantitative estimate of the probability that a customer will display a defined behavior (e.g. loan default, bankruptcy or a lower level of delinquency) with respect to their curren ...
) 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) In loan agreement, lending agreements, collateral is a Borrower, borrower's pledge (law), pledge of specific property to a lender, to Secured loan, secure repayment of a loan. ...
, 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 riskSovereign credit risk is the risk of a government becoming unwilling or unable to meet its loan obligations, as happened to Cyprus in 2013. Many countries faced sovereign risk in the Great Recession of the late-2000s. This risk can be mitigated by cr ...
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 Government debt, also known as public interest, public debt, national debt and sovereign debt, is the total amount of debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, ...
rescheduling are: *
Debt service ratioIn economics and government finance, a country’s debt service ratio is the ratio of its debt service payments (principal + interest) to its export earnings.Glossary of Statistical TermsDebt service ratio OECD, Sep 25, 2001. A country's internationa ...
*
Import ratioImport ratio, in economics and government finance, is the ratio of total imports of a country to that country’s total Foreign exchange reserves, foreign exchange (FX) reserves. The ratio can be inverted and is referred to as the reserves to imports ...
* 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 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 to financial risk might exist. The word became widely used in the 1980s, particularly at the time of the Basel I in 198 ...

counterparty
will not pay as obligated on a
bond Bond or bonds may refer to: Common meanings * Bond (finance) In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of ...
,
derivative In mathematics Mathematics (from Greek: ) includes the study of such topics as numbers (arithmetic and number theory), formulas and related structures (algebra), shapes and spaces in which they are contained (geometry), and quantities ...
,
insurance policy In insurance Insurance is a means of protection from financial loss. It is a form of risk management Risk management is the identification, evaluation, and prioritization of risk In simple terms, risk is the possibility of something ba ...
, or other contract. Financial institutions or other transaction counterparties may
hedge A hedge or hedgerow is a line of closely spaced shrub A shrub (often called a bush) is a small- to medium-sized perennial A perennial plant or simply perennial is a plant that lives more than two years. The term ('' per-'' + '' -enni ...
or take out
credit insuranceCredit insurance refers to several kinds of insurance relating to financial Credit (finance), credit: *Trade credit insurance, purchased by businesses to insure payment of credit ''extended by'' the business *Payment protection insurance, purchased ...
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 A capital requirement (also known as regulatory capital or capital adequacy) is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital adequacy ratio o ...
here is calculated using SA-CCR, the Standardized approach for counterparty credit risk. This framework replaced both non-internal model approaches: the Current Exposure Method (CEM) and the Standardised Method (SM). It is a "risk-sensitive methodology", i.e. conscious of
asset class In finance, an asset class is a group of financial instrument Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money I ...
and hedging, that differentiates between margined and non-margined trades and recognizes ; 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 In and , interest is payment from a or deposit-taking financial institution to a or depositor of an amount above repayment of the (that is, the amount borrowed), at a particular rate. It is disti ...
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 ratingA 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 Default (financ ...

credit rating
, and
loan-to-value ratio The loan-to-value (LTV) ratio is a financial term used by loan, lenders to express the ratio of a loan to the value of an asset purchased. The term is commonly used by banks and building society, building societies to represent the ratio of the fir ...
and estimates the effect on yield (
credit spread Image:2005private sector credit.PNG, px, Domestic credit to private sector in 2005 Credit (from Latin ''credit'', "''(he/she/it)'' believes") is the Trust (social sciences), trust which allows one party to provide money or resources to another pa ...
). * 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 profit Profit may refer to: Business and law * Profit (accounting), the difference between the purchase price and the costs of bringing to market * Profit (economics), normal profit and economic profit * Profit ...

dividend
s,
repurchasing shares Share repurchase (or share buyback or stock buyback) is the re-acquisition by a company of its own shares. It represents a more flexible way (relative to dividends) of returning money to shareholders. In most countries, a corporation can repurcha ...
, 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 Bond or bonds may refer to: Common meanings * Bond (finance) In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of ...
holders may
hedge A hedge or hedgerow is a line of closely spaced shrub A shrub (often called a bush) is a small- to medium-sized perennial A perennial plant or simply perennial is a plant that lives more than two years. The term ('' per-'' + '' -enni ...
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 Default may refer to: Law * Default (law), the failure to do something required by law ** Defaul ...
. * 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 used in s that have mechanically timed . The distributor's main function is to route secondary, or high voltage, from the to the s in the correct , and for the correct amount of time. Except in system ...
selling its products to a troubled
retailer Retail is the sale of goods In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or p ...
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 Concentration risk is a bank A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank o ...
.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 An X-Value Adjustment (XVA, xVA) is a collective term referring to a number of different “valuation adjustments” that banks must make when assessing the value of derivative (finance), derivative contracts that they have entered into. The purpos ...
* EAD
Exposure at default Exposure at default or (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II Basel II is the second of the Basel Accords, (now extended and partially superseded by Basel III), which are recommend ...
* EE Expected Exposure * EL
Expected loss Expected may refer to: *Expectation (epistemic) In the case of uncertainty, expectation is event that considered the most likely to happen. An expectation, which is a belief that is centered on the future, may or may not be realistic. A less advant ...
* LGD
Loss given default Loss given default or LGD is the share of an asset that is lost if a borrower defaults. It is a common parameter in risk models and also a parameter used in the calculation of economic capital, expected loss or regulatory capital under Basel I ...
* PD
Probability of default Probability of default (PD) is a financial term describing the likelihood of a default Default may refer to: Law * Default (law), the failure to do something required by law ** Default (finance) In finance Finance is the study of fina ...
* 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 fi ...

Value at risk


See also

*
Credit (finance) px, Domestic credit to private sector in 2005 Credit (from Latin Latin (, or , ) is a classical language belonging to the Italic languages, Italic branch of the Indo-European languages. Latin was originally spoken in the area around Rome, k ...
*
Default (finance) In finance, default is failure to meet the loan covenant, legal obligations (or conditions) of a loan, for example when a home buyer fails to make a mortgage loan, mortgage payment, or when a corporation or government fails to pay a Bond (finance ...
* Jarrow–Turnbull model *
Merton modelThe 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 ...


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 {{Authority control Actuarial science Banking infrastructure Financial law