Credit risk
Encyclopedia
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. 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 cost
s, which arise in a number of circumstances:
, 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. 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, 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.
Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:
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.
, credit derivative
, credit insurance
contract, or other trade or transaction when it is supposed to. 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.
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.
A good introduction can be found in a paper by Michael Pykhtin and Steven Zhu.
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
PAR Portfolio at Risk
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
. Other terms for credit risk are default risk and counterparty risk.
Investor losses include lost principal and interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
, decreased cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
, and increased collection cost
Collection cost
A collection cost is incurred to collect debt that is owed. This could include expenditures for hiring a collection agency. Some contracts and regulations prescribe liquidated damages for collection costs. When collection costs occur, the debtor has pay off debt to get the collector out of...
s, which arise in a number of circumstances:
- A consumer does not make a payment due on a mortgage loanMortgage loanA mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
, credit cardCredit cardA credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
, line of creditLine of creditA line of credit is any credit source extended to a government, business or individual by a bank or other financial institution. A line of credit may take several forms, such as overdraft protection, demand loan, special purpose, export packing credit, term loan, discounting, purchase of...
, 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 invoiceTrade creditTrade credit is an arrangement between businesses to buy goods or services on account, that is, without making immediate cash payment. The supplier typically provides the customer with an agreement to bill them later, stipulating a fixed number of days or other date by which the customer should pay...
when due - A business does not pay an employee's earned wageWageA wage is a compensation, usually financial, received by workers in exchange for their labor.Compensation in terms of wages is given to workers and compensation in terms of salary is given to employees...
s when due - A business or government bondBond (finance)In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
issuer does not make a payment on a couponCoupon (bond)A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
or principal payment when due - An insolvent insurance company does not pay a policy obligation
- An insolvent bankBankA bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
won't return funds to a depositor - A government grants bankruptcyBankruptcyBankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
protection to an insolventInsolvencyInsolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...
consumer or business
Types of credit risk
Credit risk can be classified in the following way:- 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
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 third party provided intelligence. Companies like Standard & Poor'sStandard & Poor's
Standard & Poor's is a United States-based financial services company. It is a division of The McGraw-Hill Companies that publishes financial research and analysis on stocks and bonds. It is well known for its stock-market indices, the US-based S&P 500, the Australian S&P/ASX 200, the Canadian...
, Moody's Analytics
Moody's Analytics
Moody’s Analytics provides capital markets and risk management professionals with credit analysis, economic research, financial risk management software, and advisory services...
, Fitch Ratings
Fitch Ratings
The Fitch Group is a majority-owned subsidiary of FIMALAC, headquartered in Paris. Fitch Ratings, Fitch Solutions and Algorithmics, are part of the Fitch Group....
, and Dun and Bradstreet provide such information for a fee.
Most lenders employ their own models (credit scorecards
Credit Scorecards
Credit scorecards are mathematical models which attempt to provide a quantitative estimate of the probability that a customer will display a defined behavior Credit scorecards are mathematical models which attempt to provide a quantitative estimate of the probability that a customer will display a...
) 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, risk is controlled through the setting of credit limits. Some products also require security
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
, 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.
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. 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.Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:
- Debt service ratioDebt service ratioIn economics and government finance, debt service ratio is the ratio of debt service payments of a country to that country’s export earnings. A country's international finances are healthier when this ratio is low...
- 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.
Counterparty risk
Counterparty risk, known as default risk, is the risk that an organization does not pay out on a bondBond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, credit derivative
Credit derivative
In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself...
, credit insurance
Credit insurance
Credit insurance is a term used to describe both business credit insurance and consumer credit insurance, e.g., credit life insurance, credit disability insurance Credit insurance is a term used to describe both business credit insurance (a.k.a. trade credit insurance) and consumer credit...
contract, or other trade or transaction when it is supposed to. 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.
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
AIG
AIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...
.
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.
A good introduction can be found in a paper by Michael Pykhtin and Steven Zhu.
Mitigating credit risk
Lenders mitigate credit risk using several methods:- Risk-based pricing: Lenders generally charge a higher interestInterestInterest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
rate to borrowers who are more likely to default, a practice called risk-based pricingRisk-based pricingRisk-based pricing is a methodology adopted by many lenders in the mortgage and financial services industries. It has been in use for many years as lenders try to measure loan risk in terms of interest rates and other fees...
. Lenders consider factors relating to the loan such as loan purposeLoan PurposePertaining to mortgages and their risk based pricing factors, the loan purpose factor is sub-categorized by purchase, Rate & term refinance and cash-out refinance....
, credit ratingCredit ratingA credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
, and loan-to-value ratio and estimates the effect on yield (credit spreadCredit spread (bond)The financial term, credit spread is the yield spread, or difference in yield between different securities, due to different credit quality. The credit spread reflects the additional net yield an investor can earn from a security with more credit risk relative to one with less credit risk...
). - Covenants: Lenders may write stipulations on the borrower, called covenantsLoan covenantA loan covenant is a condition in a commercial loan or bond issue that requires the borrower to fulfill certain conditions or which forbids the borrower from undertaking certain actions, or which possibly restricts certain activities to circumstances when other conditions are met.Typically,...
, into loan agreements:- Periodically report its financial condition
- Refrain from paying dividendDividendDividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
s, repurchasing sharesShare repurchaseStock repurchase is the reacquisition by a company of its own stock. In some countries, including the U.S. and the UK, a corporation can repurchase its own stock by distributing cash to existing shareholders in exchange for a fraction of the company's outstanding equity; that is, cash is exchanged...
, 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 ratioTimes interest earnedTimes interest earned or interest coverage ratio is a measure of a company's ability to honor its debt payments. It may be calculated as either EBIT or EBITDA divided by the total interest payable....
- Credit insurance and credit derivatives: Lenders and bondBond (finance)In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
holders may hedge their credit risk by purchasing credit insuranceCredit insuranceCredit insurance is a term used to describe both business credit insurance and consumer credit insurance, e.g., credit life insurance, credit disability insurance Credit insurance is a term used to describe both business credit insurance (a.k.a. trade credit insurance) and consumer credit...
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 swapCredit default swapA credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
. - Tightening: Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a distributorDistribution (business)Product distribution is one of the four elements of the marketing mix. An organization or set of organizations involved in the process of making a product or service available for use or consumption by a consumer or business user.The other three parts of the marketing mix are product, pricing,...
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 riskConcentration riskConcentration risk is a banking term denoting the overall spread of a bank's outstanding accounts over the number or variety of debtors to whom the bank has lent money. This risk is calculated using a "concentration ratio" which explains what percentage of the outstanding accounts each bank loan...
. Lenders reduce this risk by diversifyingDiversification (finance)In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of...
the borrower pool. - Deposit insurance: Many governments establish deposit insuranceDeposit insuranceExplicit deposit insurance 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...
to guarantee bank deposits of insolvent banks. Such protection discourages consumers from withdrawing money when a bank is becoming insolvent, to avoid a bank runBank runA bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
, and encourages consumers to hold their savings in the banking system instead of in cash.
Credit risk related acronyms
ACPM Active credit portfolio managementEAD 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
PAR Portfolio at Risk
Further reading
- Principles for the management of credit risk from the Bank for International Settlement
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.