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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), failure to satisfy the terms of a loan obligation or failure to pay back a loan ** Default judgment, a binding judgment in favor of eit ...
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 debtor, 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 ...
, disruption to
cash flow A cash flow is a real or virtual movement of cash, 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 exp ...
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 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 ...
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 (), in civil law (legal system), 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 ...
,
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 credit card issuer, card issuer to pay them for the ...
,
line of credit A line of credit is a Credit (finance), credit facility extended by a bank or other financial institution to a government, business or Personal finance, individual customer that enables the customer to draw on the facility when the customer nee ...
, or other loan. * A
company A company, abbreviated as co., is a legal entity representing an association of people, whether natural, legal or a mixture of both, with a specific objective. Company members share a common purpose and unite to achieve specific, declared ...
is unable to repay asset-secured fixed or
floating charge A floating charge is a security interest In finance, 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 (finance), collateral'') which enables the creditor ...
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 Worker, employee for work (human activity), work done in a specific period of time. Some examples of wage payments include wiktionary:compensatory, compensatory payments such as ''minimum wage'', ''p ...
s when due. * A business or government
bond Bond or bonds may refer to: Common meanings * Bond (finance), a type of debt security * Bail bond, a commercial third-party guarantor of surety bonds in the United States * Chemical bond, the attraction of atoms, ions or molecules to form chemical ...
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 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. Beca ...
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 creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debt ...
protection to an
insolvent In accounting, insolvency is the state of being unable to pay the debts, by a Natural person, person or company (debtor), at Maturity (finance), maturity; those in a state of insolvency are said to be ''insolvent''. There are two forms: Cash flow ...
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 Mortgage insurance (also known as mortgage guarantee and home-loan insurance) is an insurance policy In insurance, the insurance policy is a contract (generally a standard form contract) between the insurer and the policyholder, which determines t ...
, or seek
security Security is protection from, or resilience against, potential harm (or other unwanted Coercion, coercive change) caused by others, by restraining the freedom of others to act. Beneficiaries (technically referents) of security may be of persons an ...
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, th ...
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. *
Concentration risk Concentration risk is a 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 ...
– 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 capital stock, stocks, Bond (finance), bonds, ...
,
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 international ...
,
Fitch Ratings Fitch Ratings Inc. is an American credit rating agency and is one of the "Big Three (credit rating agencies), Big Three credit rating agencies", the other two being Moody's and Standard & Poor's. It is one of the three nationally recognized statis ...
,
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 millio ...
,
Dun and Bradstreet The Dun & Bradstreet Corporation is an American company that provides commercial data, analytics, and insights for businesses. Headquartered in Jacksonville, Florida Jacksonville is a city located on the Atlantic coast of northeast Florida, ...
,
Bureau van Dijk Bureau van Dijk is a major publisher of business information, and specialises in private company data combined with software for searching and analysing companies. It is a Moody's Analytics company. Orbis is Bureau van Dijk's flagship company ...
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 Credit analysis is the understanding and evaluation to check if an individual, organization, or business is worthy of credit. Credit Risk scorecards are mathematical models which use a formula that consists of data elements or variables that are us ...
) 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, 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 Sovereign credit risk is the risk of a government becoming unwilling or unable to meet its loan In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. T ...
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 A country's gross government debt (also called public debt, or sovereign debt) is the financial liabilities of the government sector. Changes in government debt over time reflect primarily borrowing due to past government deficits. A deficit oc ...
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 or counterparty credit risk (CCR), is a risk that a
counterparty A counterparty (sometimes contraparty) is a Juristic person, 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 ...
will not pay as obligated on a
bond Bond or bonds may refer to: Common meanings * Bond (finance), a type of debt security * Bail bond, a commercial third-party guarantor of surety bonds in the United States * Chemical bond, the attraction of atoms, ions or molecules to form chemical ...
,
derivative In mathematics Mathematics is an area of knowledge that includes the topics of numbers, formulas and related structures, shapes and the spaces in which they are contained, and quantities and their changes. These topics are represented ...
,
insurance policy In insurance, the insurance policy is a contract (generally a standard form contract) between the insurer and the policyholder, which determines the claim (legal), claims which the insurer is law, legally required to pay. In exchange for an initial ...
, 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 adjoini ...
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 A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a bank A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simulta ...
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 In finance, an asset class is a group of financial instrument Financial instruments are monetary Contract, contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership in ...
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, th ...
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 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 an ...
, 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 Real estate is property consisting of land and the buildings on it, along with its natural ...
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 Profit (accounting), 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 ...
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 The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leverage (finance), leveraging, the ratio is also known as risk, gearing o ...
or interest coverage ratio. * Credit insurance and credit derivatives – Lenders and
bond Bond or bonds may refer to: Common meanings * Bond (finance), a type of debt security * Bail bond, a commercial third-party guarantor of surety bonds in the United States * Chemical bond, the attraction of atoms, ions or molecules to form chemical ...
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 adjoini ...
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 Swap (finance), financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt Default (finance), default (by the debtor) or other credit event. That is, the seller of the ...
. * 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 engine, spark-ignition internal combustion engines that have mechanically timed ignition system, ignition. The distributor's main function is to route high voltage Electric c ...
selling its products to a troubled
retailer Retail is the sale of goods and Service (economics), services to consumers, in contrast to wholesaling, which is sale to business or institutional customers. A retailer purchases goods in large quantities from manufacturing, manufacturers, dire ...
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 deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly ...
.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 Credit valuation adjustments (CVAs) are accounting adjustments made to reserve a portion of profits on uncollateralized financial derivatives. They are charged by a bank to a risky (capable of default) counterparty to compensate the bank for taking ...
* DVA Debit Valuation Adjustment – see
XVA An X-Value Adjustment (XVA, xVA) is an umbrella term In linguistics, semantics, general semantics, and ontology components, ontologies, hyponymy () is a wikt:Wiktionary:Semantic relations, semantic relation between a hyponym denoting a subset, ...
* 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 In finance, a loan is the lending of money by one or more individuals, organizations, or other entities ...
* 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 Expected loss is the sum of the value ...
* PD
Probability of default Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations. PD is used in a variet ...
* PFE
Potential future exposure {{Unreferenced, date=March 2007 Potential future exposure (PFE) is the maximum expected credit exposure over a specified period of time calculated at some level of confidence (i.e. at a given quantile In statistics and probability, quantiles ar ...
* 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 (social sciences), trust which allows one Party (law), party to provide money or resources to another party wherein the second party does not reimburse the first party im ...
*
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 (financ ...
*
Distressed securities Distressed securities are securities A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use th ...
*
Jarrow–Turnbull model The Jarrow–Turnbull model is a widely used "reduced-form" credit 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 include ...
* Merton model * 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 {{Authority control Actuarial science Banking infrastructure Financial law