Credit risk

Categories of financial risk
Credit risk Concentration risk
Market risk Interest rate risk Currency risk Equity risk Commodity risk
Liquidity risk Refinancing risk
Operational risk Legal risk Political risk
Reputational risk
Volatility risk
Settlement risk
Profit risk
Systemic risk
v · d · e

Basel II

Bank for International Settlements Basel Accords - Basel I Basel II

Background

Banking Monetary policy - Central bank Risk - Risk management Regulatory capital Tier 1 - Tier 2

Pillar 1: Regulatory Capital

Credit risk Standardized - IRB Approach F-IRB - A-IRB PD - LGD - EAD Operational risk Basic - Standardized - AMA Market risk Duration - Value at risk

Pillar 2: Supervisory Review

Economic capital Liquidity risk - Legal risk

Pillar 3: Market Disclosure

Disclosure

Business and Economics Portal

Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised^[1]. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk.

Investor losses include lost principal and interest, decreased cash flow, and increased collection costs, which arise in a number of circumstances^[2]:

• A consumer does not make a payment due on a mortgage loan, credit card, line of credit, or other loan
• A business does not make a payment due on a mortgage, credit card, line of credit, or other loan
• 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 won't return funds to a depositor
• A government grants bankruptcy protection to an insolvent consumer or business

Types of credit risk

Credit risk can be classified in the following way:^[3]

• Credit Default Risk - The risk of loss when the bank considers that the obligor is unlikely to pay its credit obligations in full or the obligor 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 when a sovereign state freezes foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk).

Assessing credit risk

Main articles: Credit analysis and Consumer 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 third party provided intelligence. Companies like Standard & Poor's, Moody's Analytics, Fitch Ratings, and Dun and Bradstreet provide such information for a fee.

Most lenders employ their own 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, risk is controlled through the setting of credit limits. Some products also require security, most commonly in the form of property.

Credit scoring models also form part of the framework used by banks or lending institutions 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).

Credit risk has been shown to be particularly large and particularly damaging for very large investment projects, so-called megaprojects. This is because such projects are especially prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays, etc. – the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt.^[8]

Sovereign risk

Sovereign risk is the risk of a government becoming unwilling or unable to meet its loan obligations, or reneging on loans it guarantees.^[9] The existence of sovereign 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.^[10]

Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:^[11]

• 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, variance of export revenue and domestic money supply growth. Frenkel, Karmann and Scholtens also argue that the likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity gains. Saunders argues that rescheduling can become more likely 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.^[12]

Counterparty risk

Counterparty risk, known as default risk, is the risk that an organization does not pay out on a bond, credit derivative, credit insurance contract, or other trade or transaction when it is supposed to.^[13] Even organizations who think that they have hedged their bets by buying credit insurance of some sort still face the risk that the insurer will be unable to pay, either due to temporary liquidity issues or longer term systemic issues.^[14]

Large insurers are counterparties to many transactions, and thus this is the kind of risk that prompts financial regulators to act, e.g., the bailout of insurer AIG.

On the methodological side, counterparty risk can be affected by wrong way risk, namely the risk that different risk factors be correlated in the most harmful direction. Including correlation between the portfolio risk factors and the counterparty default into the methodology is not trivial, see for example Brigo and Pallavicini.^[15]

A good introduction can be found in a paper by Michael Pykhtin and Steven Zhu.^[16]

Mitigating credit risk

Lenders mitigate credit risk using several methods:

• Risk-based pricing: Lenders generally 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^[17]: Lenders may write stipulations on the borrower, called covenants, into loan agreements:
  • 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
  • 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^[18]: Lenders to a small number of borrowers (or kinds of borrower) face a high degree of unsystematic credit risk, called concentration risk. Lenders reduce this risk by diversifying the borrower pool.
• Deposit insurance: Many governments establish deposit insurance to guarantee bank deposits of insolvent banks. Such protection discourages consumers from withdrawing money when a bank is becoming insolvent, to avoid a bank run, and encourages consumers to hold their savings in the banking system instead of in cash.

Credit risk related acronyms

ACPM Active credit portfolio management

EAD Exposure at default

EL Expected loss

ERM Enterprise risk management

LGD Loss given default

PD Probability of default

KMV quantitative credit analysis solution acquired by credit rating agency Moody's^[19]

PAR Portfolio at Risk

See also

• Credit (finance)
• Default (finance)

Further reading

• Bluhm, Christian, Ludger Overbeck, and Christoph Wagner (2002). An Introduction to Credit Risk Modeling. Chapman & Hall/CRC. ISBN 978-1584883265. 
• 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 1-904339-76-X. 
• de Servigny, Arnaud and Olivier Renault (2004). The Standard & Poor's Guide to Measuring and Managing Credit Risk. McGraw-Hill. ISBN 978-0071417556. 
• Darrell Duffie and Kenneth J. Singleton (2003). Credit Risk: Pricing, Measurement, and Management. Princeton University Press. ISBN 978-0691090467. 
• Principles for the management of credit risk from the Bank for International Settlement

References

1. ^ Item 2:Principles for the management of credit risk
2. ^ Risk Glossary:Credit Risk
3. ^ Credit Risk Classification
4. ^ BIS Paper:Sound credit risk assessment and valuation for loans
5. ^ Huang and Scott:Credit Risk Scorecard Design, Validation and User Acceptance
6. ^ Investopedia:Risk-based mortgage pricing
7. ^ Edelman:Risk based pricing for personal loans
8. ^ Bent Flyvbjerg, Nils Bruzelius, and Werner Rothengatter, 2003, Megaprojects and Risk: An Anatomy of Ambition (Cambridge University Press).
9. ^ Country Risk and Foreign Direct Investment. Duncan H. Meldrum (1999)
10. ^ Cary L. Cooper, Derek F. Channon (1998). The Concise Blackwell Encyclopedia of Management. ISBN 978-0-631-20911-9. 
11. ^ Frenkel, Karmann and Scholtens (2004). Sovereign Risk and Financial Crises. Springer. ISBN 978-3-540-22248-4. 
12. ^ Cornett, Marcia Millon and Saunders, Anthony (2006). Financial Institutions Management: A Risk Management Approach, 5th Edition. McGraw Hill. ISBN 978-0-07-304667-9. 
13. ^ Investopedia. Counterparty risk. Retrieved 2008-10-06
14. ^ Tom Henderson. Counterparty Risk and the Subprime Fiasco. 2008-01-02. Retrieved 2008-10-06
15. ^ Brigo, Damiano and 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 158488925X. Related SSRN Research Paper
16. ^ A Guide to Modeling Counterparty Credit Risk, GARP Risk Review,July–August 2007 Related SSRN Research Paper
17. ^ Debt covenants
18. ^ MBA Mondays:Risk Diversification
19. ^ On the equivalence of the KMV and maximum likelihood methods for structural credit risk models

External links

• The Risk Management Association - leading industry organisation for credit risk professionals
• Defaultrisk.com - web site maintained by Greg Gupton with research and white papers on credit risk modelling.