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Credit risk

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Credit riskis the possibility of losing a lender holds due to a risk ofdefaulton 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 lostprincipalandinterest,disruption tocash flows,and increasedcollection 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 asyield spreadscan be used to infer credit risk levels based on assessments by market participants.

Losses can arise in a number of circumstances,[2]for example:

To reduce the lender's credit risk, the lender may perform acredit checkon the prospective borrower, may require the borrower to take out appropriate insurance, such asmortgage insurance,or seeksecurityover some assets of the borrower or aguaranteefrom 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 theinterest ratethat the debtor will be asked to pay on the debt. Credit risk mainly arises when borrowers are unable or unwilling to pay.

Types[edit]

A credit risk can be of the following types:[3]

  • 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 andderivatives.
  • 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[edit]

Main articles:Credit analysisandConsumer credit risk

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 requirecollateral,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 andliquidity 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[edit]

Sovereign credit riskis 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 thelate-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 ofsovereign debtrescheduling are:[13]

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[edit]

A counterparty risk, also known as asettlement riskorcounterparty credit risk(CCR), is a risk that acounterpartywill not pay as obligated on abond,derivative,insurance policy,or other contract.[15] Financial institutions or other transaction counterparties mayhedgeor take outcredit insuranceor, 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]

Thecapital requirementhere is calculated using SA-CCR, thestandardized 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 ofasset classandhedging,that differentiates betweenmarginedand non-margined trades and recognizesnetting benefits;issues insufficiently addressed under the preceding frameworks.

Mitigation[edit]

Lenders mitigate credit risk in a number of ways, including:

  • Risk-based pricing– Lenders may charge a higherinterest rateto borrowers who are more likely to default, a practice calledrisk-based pricing.Lenders consider factors relating to the loan such asloan purpose,credit rating,andloan-to-value ratioand estimates the effect on yield (credit spread).
  • Covenants– Lenders may write stipulations on the borrower, calledcovenants,into loan agreements, such as:[19]
    • Periodically report its financial condition,
    • Refrain from payingdividends,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'sdebt-to-equity ratioorinterest coverage ratio.
  • Credit insuranceandcredit derivatives– Lenders andbondholders mayhedgetheir credit risk by purchasingcredit insuranceorcredit derivatives.These contracts transfer the risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is thecredit default swap.
  • Tightening– Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, adistributorselling its products to a troubledretailermay attempt to lessen credit risk by reducing payment terms fromnet 30tonet 15.
  • Diversification– Lenders to a small number of borrowers (or kinds of borrower) face a high degree ofunsystematiccredit risk, calledconcentration risk.[20]Lenders reduce this risk bydiversifyingthe borrower pool.
  • Deposit insurance– Governments may establishdeposit insuranceto 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 Initialisms[edit]

See also[edit]

References[edit]

  1. ^"Principles for the Management of Credit Risk – final document".Basel Committee on Banking Supervision.BIS. September 2000.Retrieved13 December2013.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
  3. ^Credit Risk ClassificationArchived2013-09-27 at theWayback Machine
  4. ^BIS Paper:Sound credit risk assessment and valuation for loans
  5. ^"Huang and Scott: Credit Risk Scorecard Design, Validation and User Acceptance"(PDF).Archived fromthe original(PDF)on 2012-04-02.Retrieved2011-09-22.
  6. ^Investopedia: Risk-based mortgage pricing
  7. ^"Edelman: Risk-based pricing for personal loans"(PDF).Archived fromthe original(PDF)on 2012-04-02.Retrieved2011-09-22.
  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".Review of Financial Studies.10(2): 481–523.doi:10.1093/rfs/10.2.481.ISSN0893-9454.S2CID154117131.
  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.ISBN978-0-631-20911-9.
  13. ^abFrenkel, Karmann and Scholtens (2004).Sovereign Risk and Financial Crises.Springer.ISBN978-3-540-22248-4.
  14. ^Cornett, Marcia Millon; Saunders, Anthony (2006).Financial Institutions Management: A Risk Management Approach, 5th Edition.McGraw-Hill.ISBN978-0-07-304667-9.
  15. ^Investopedia.Counterparty risk.Retrieved 2008-10-06
  16. ^Tom Henderson.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.ISBN978-1-58488-925-0.Related SSRN Research Paper
  18. ^Orlando, Giuseppe; Bufalo, Michele; Penikas, Henry; Zurlo, Concetta (2021-10-28),"Distributions Commonly Used in Credit and Counterparty Risk Modeling",Modern Financial Engineering,Topics in Systems Engineering, vol. 2, WORLD SCIENTIFIC, pp. 3–23,doi:10.1142/9789811252365_0001,ISBN978-981-12-5235-8,S2CID245970287,retrieved2022-04-10
  19. ^Debt covenants
  20. ^MBA Mondays:Risk Diversification
  21. ^Moody's Analytics(2008).A Brief History of Active Credit Portfolio Management

Further reading[edit]

External links[edit]

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