Credit risk

Credit risk is the possibility of losing a lender holds due to a risk of default on a debt that may arise from a
borrower failing to make required payments.[1] In the first resort, the risk is 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. 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,[2] 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 will not 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 over
some assets of the borrower or a guarantee 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 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:[3]

Credit default risk (https://www.investopedia.com/terms/d/defaultrisk.asp#:~:text=Default%20

risk%20is%20the%20risk,all%20forms%20of%20credit%20extensions.) – 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 (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.[4] 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. Nationally recognized statistical rating
organizations 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.[5] With products such as unsecured personal loans or mortgages,
lenders charge a higher price for higher-risk customers and vice versa.[6][7] 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.[8]

Credit scoring models also form part of the framework used by banks or lending institutions to grant credit
to clients.[9] 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).[10][11]

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 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.[12]

Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:[13]

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.[13] 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.[14]

Counterparty risk

A counterparty risk, also known as a default risk or counterparty credit risk (CCR), is a risk that a
counterparty will not pay as obligated on a bond, derivative, insurance policy, or other contract.[15]
Financial institutions or other transaction counterparties may hedge 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.[16] 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.[17][18]

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 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 (credit spread).
Covenants – Lenders may write stipulations on the borrower, called covenants, into loan
agreements, such as:[19]
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, 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 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.
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 (or kinds of borrower) face a high
degree of unsystematic credit risk, called concentration risk.[20] Lenders reduce this risk by
diversifying the borrower pool.
 Deposit insurance – Governments may establish deposit insurance 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 [21]
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
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

See also
Credit (finance)
Default (finance)
Distressed securities
Jarrow–Turnbull model
KMV model
Merton model
Criticism of credit scoring systems in the United States

References
1. "Principles for the Management of Credit Risk – final document" (http://www.bis.org/publ/bcb
s75.htm). Basel Committee on Banking Supervision. BIS. September 2000. Retrieved
13 December 2013. "Credit risk is most simply defined as the potential that a bank borrower
or counterparty will fail to meet its obligations in accordance with agreed terms."
2. Risk Glossary: Credit Risk (http://www.riskglossary.com/link/credit_risk.htm)
3. Credit Risk Classification (https://www.unicreditgroup.eu/en/investors/risk-management/cred
it.html) Archived (https://web.archive.org/web/20130927181311/https://www.unicreditgroup.e
u/en/investors/risk-management/credit.html) 2013-09-27 at the Wayback Machine
4. BIS Paper:Sound credit risk assessment and valuation for loans (http://www.bis.org/publ/bcb
s126.htm)
5. "Huang and Scott: Credit Risk Scorecard Design, Validation and User Acceptance" (https://
web.archive.org/web/20120402191742/http://www.crc.man.ed.ac.uk/conference/archive/200
7/papers/huang-and-scott.pdf) (PDF). Archived from the original (http://www.crc.man.ed.ac.u
k/conference/archive/2007/papers/huang-and-scott.pdf) (PDF) on 2012-04-02. Retrieved
2011-09-22.
 6. Investopedia: Risk-based mortgage pricing (http://www.investopedia.com/terms/r/risk-based
_mortgage_pricing.asp)
7. "Edelman: Risk-based pricing for personal loans" (https://web.archive.org/web/2012040219
1751/http://www.crc.man.ed.ac.uk/conference/archive/2003/presentations/edelman.pdf)
(PDF). Archived from the original (http://www.crc.man.ed.ac.uk/conference/archive/2003/pres
entations/edelman.pdf) (PDF) on 2012-04-02. Retrieved 2011-09-22.
8. Berger, Allen N., and Gregory F. Udell. "Collateral, loan quality and bank risk."Journal of
Monetary Economics 25.1 (1990): 21–42.
9. Jarrow, R. A.; Lando, D.; Turnbull, S. M. (1997). "A Markov Model for the Term Structure of
Credit Risk Spreads" (https://doi.org/10.1093%2Frfs%2F10.2.481). Review of Financial
Studies. 10 (2): 481–523. doi:10.1093/rfs/10.2.481 (https://doi.org/10.1093%2Frfs%2F10.2.4
81). ISSN 0893-9454 (https://www.worldcat.org/issn/0893-9454). S2CID 154117131 (https://
api.semanticscholar.org/CorpusID:154117131).
10. Altman, Edward I., and Anthony Saunders. "Credit risk measurement: Developments over
the last 20 years." Journal of Banking & Finance 21.11 (1997): 1721–1742.
11. Mester, Loretta J. "What's the point of credit scoring?." Business review 3 (1997): 3–16.
12. Cary L. Cooper; Derek F. Channon (1998). The Concise Blackwell Encyclopedia of
Management (https://archive.org/details/conciseblackwell0000unse). ISBN 978-0-631-
20911-9.
13. Frenkel, Karmann and Scholtens (2004). Sovereign Risk and Financial Crises. Springer.
ISBN 978-3-540-22248-4.
14. Cornett, Marcia Millon; Saunders, Anthony (2006). Financial Institutions Management: A
Risk Management Approach, 5th Edition. McGraw-Hill. ISBN 978-0-07-304667-9.
15. Investopedia. Counterparty risk (http://www.investopedia.com/terms/c/counterpartyrisk.asp).
Retrieved 2008-10-06
16. Tom Henderson. Counterparty Risk and the Subprime Fiasco (https://seekingalpha.com/artic
le/58780-counterparty-risk-and-the-subprime-fiasco). 2008-01-02. Retrieved 2008-10-06
17. Brigo, Damiano; Andrea Pallavicini (2007). Counterparty Risk under Correlation between
Default and Interest Rates. In: Miller, J., Edelman, D., and Appleby, J. (Editors), Numerical
Methods for Finance. Chapman Hall. ISBN 978-1-58488-925-0.Related SSRN Research
Paper (http://ssrn.com/abstract=926067)
18. Orlando, Giuseppe; Bufalo, Michele; Penikas, Henry; Zurlo, Concetta (2021-10-28),
"Distributions Commonly Used in Credit and Counterparty Risk Modeling" (https://www.worl
dscientific.com/doi/10.1142/9789811252365_0001), Modern Financial Engineering, Topics
in Systems Engineering, WORLD SCIENTIFIC, vol. 2, pp. 3–23,
doi:10.1142/9789811252365_0001 (https://doi.org/10.1142%2F9789811252365_0001),
ISBN 978-981-12-5235-8, S2CID 245970287 (https://api.semanticscholar.org/CorpusID:245
970287), retrieved 2022-04-10
19. Debt covenants (http://moneyterms.co.uk/debt_covenants/)
20. MBA Mondays:Risk Diversification (http://www.businessinsider.com/mba-mondays-diversific
ation-2010-6)
21. Moody's Analytics (2008). A Brief History of Active Credit Portfolio Management (https://www.
moodysanalytics.com/-/media/whitepaper/before-2011/03-25-08-a-brief-history-of-active-cre
dit-portfolio-management.pdf)

Further reading
Bluhm, Christian; Ludger Overbeck & Christoph Wagner (2002). An Introduction to Credit
Risk Modeling. Chapman & Hall/CRC. ISBN 978-1-58488-326-5.
 Damiano Brigo and Massimo Masetti (2006). Risk Neutral Pricing of Counterparty Risk, in:
Pykhtin, M. (Editor), Counterparty Credit Risk Modeling: Risk Management, Pricing and
Regulation. Risk Books. ISBN 978-1-904339-76-2.
Orlando, Giuseppe; Bufalo Michele; Penikas Henry; Zurlo Concetta (2022). Modern
Financial Engineering: Counterparty, Credit, Portfolio and Systemic Risks. World Scientific.
ISBN 978-981-125-235-8.
de Servigny, Arnaud; Olivier Renault (2004). 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 (2003). Credit Risk: Pricing, Measurement, and
Management. Princeton University Press. ISBN 978-0-691-09046-7.
Principles for the management of credit risk (http://www.bis.org/publ/bcbs75.htm) from the
Bank for International Settlements

External links
Bank Management and Control (https://www.springer.com/gp/book/9783030428655),
Springer Nature – Management for Professionals, 2020
Credit Risk Modelling (https://www.crif.in/products-and-services/predictive-analytics-scoreca
rds), - information on credit risk modelling and decision analytics
A Guide to Modeling Counterparty Credit Risk (http://ssrn.com/abstract_id=1032522) –
SSRN Research Paper, July 2007
Defaultrisk.com (https://web.archive.org/web/20090804080317/http://defaultrisk.com/) –
research and white papers on credit risk modelling
The Journal of Credit Risk (http://www.risk.net/type/technical-paper/source/journal-of-credit-ri
sk/) publishes research on credit risk theory and practice.
Soft Data Modeling Via Type 2 Fuzzy Distributions for Corporate Credit Risk Assessment in
Commercial Banking (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3206607) SSRN
Research Paper, July 2018

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