Credit Risk Definition
The term “Credit Risk” refers to the probability of a loss owing to the failure of the borrower fails to repay the loan or meet debt obligations. In other words, it refers to the possibility that the lender or creditor may not receive the principal and interest component of the debt resulting in interrupted cash flow and increased cost of collection. Further, it also covers other similar risks, such as the risk that the bond issuer may not be able to make payment at the time of its maturity or the risk arising out of the inability of the insurance company to pay the claim. In order to mitigate credit risk, lenders usually use various credit monitoring techniques to assess the credibility of the prospective borrower.
Types of Credit Risk
It can be broadly categorized into three types – credit default risk, concentration risk, and country risk. Now, let us have a look at each of them separately:
#1 – Credit Default Risk
Credit default risk covers the type of loss that is incurred by the lender either when the borrower is unable to repay the amount in full or when the borrower is already 90 days past the due date of the debt repayment. This type of credit risk influences almost all the financial transactions that are based on credit like securities, bonds, loans or derivatives. Credit default risk is the reason why all the banks perform a thorough credit background of its prospective customers before approving them any credit cards or personal loans.
#2 – Concentration Risk
Concentration risk is the type of risk which arises out of significant exposure to any individual or group because any adverse occurrence will have the potential to inflict large losses to the core operations of a bank. The concentration risk is usually associated with significant exposure to a single company or industry or individual.
#3 – Country Risk
Country risk is the type of risk that is seen when a sovereign state halts the payments for foreign currency obligations overnight that results in default. Country risk is mainly influenced by a country’s macroeconomic performance, while the political stability of a country also plays a pivotal role. Country risk is also known as sovereign risk.
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Formula of Credit Risk
One of the simplest methods for calculating credit risk loss is the formula for expected loss which is computed as the product of the probability of default (PD), exposure at default (EAD) and one minus loss given default (LGD). Mathematically, it is represented as,
Examples of Credit Risk
Let’s see some simple examples of Credit Risk to understand it better.
Credit Risk Example #1
Let us assume that a credit of $1,000,000 was extended to a company one year ago. In the current year, the company has started to experience some operational difficulties resulting in a liquidity crunch. Determine the expected loss for the exposure if the company defaults. Please note the loss given default is 55%.
Given,
- Exposure at default, EAD = $1,000,000
- Probability of default, PD = 100% (as the company is assumed to be in default)
- Loss given default, LGD = 68%
Therefore, the expected loss can be calculated using the above formula as,
= 100% * $1,000,000 * (1 – 55%)
Expected Loss = $450,000
Therefore, the expected loss for this exposure is $450,000.
Credit Risk Example #2
Let us assume that ABC Bank Ltd has lent a loan of $2,500,000 to a company that is into the real estate business. According to the bank’s internal rating scale, the company has been rated at A taking into account the cyclicality witnessed in the industry. The probability of default and loss have given default corresponding to the internal rating are 0.10% and 68% respectively. Determine the expected loss for ABC Bank Ltd based on the given information.
Given,
- Exposure at default, EAD = $2,500,000
- Probability of default, PD = 0.10%
- Loss given default, LGD = 68%
Therefore, the expected loss can be calculated using the above formula as,
= 0.10% * $2,500,000 * (1 – 68%)
Expected loss = $800
Therefore, the expected loss for ABC Bank Ltd from this exposure is $800.
Advantages
- A robust credit risk management improves the ability to predict and forecast which helps in measurement of the potential risk in any transaction.
- The banks can utilize credit risk models to assess the level of lending that can be funded to prospective or new borrowers.
- It can be used as an alternative to the traditional strategies and techniques for pricing and hedging options.
Disadvantages
- Despite having several quantitative techniques to measure credit risk, the lenders have to resort to some judgments since it is still not possible to assess the entire risk scientifically.
- Robust risk management can be a very costly affair.
- There are a plethora of credit risk models available and as such it is tough for the lenders to decide on which one to use. Usually, the lenders use one of the models and take one model fits all approach, which is fundamentally wrong.
Conclusion
Most of the banks have improved their credit risk management by employing innovative technologies. Such innovations have enhanced the ability of the banks to measure, identify and control credit risk as part of Basel III implementation.
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