What is the Credit Risk Definition?
Credit risk refers to the risk of a loss a lender faces if the borrower, irrelevant if it is a private borrower, a corporate one, or a government, is unable to repay the loan, the principal, an interest payment, a coupon payment, or to meet other contractual obligations. Another way of looking at credit risk is to view it as a borrower’s creditworthiness and the ability to repay a loan.
A more specific credit risk definition is the interruption of cash flow of the lender and an increase in collection costs. Lenders conduct a credit risk analysis to determine the credit risk. Higher-risk borrowers must accept higher interest rate payments or more substantial collateral to receive a loan, which usually applies in an efficient credit market as part of a sound financial system.
Lender use credit spreads, or yield spreads, as part of their credit risk management. They also assist risk management teams with a credit risk assessment of market participants.
A Credit Risk Example and The Impacts of Wrong Credit Risk Modeling
The below example will help understand the credit risk definition and provide a simplified illustration of how a lender may approach a loan.
Below is a simple formula a lender may use as part of their credit risk assessment to compute their loss given default or LGD. LGD is the net amount a lender will lose if the borrower fails to repay a loan, expressed as a percentage of the total loan.
The simplified formula is:
Expected Loss = PD x EAD x LGD
- PD = Probability of Default
- EAD = Exposure at Default
- LGD = Loss Given Default
Noteworthy:
- If LGD is unavailable, the standard formula is 1 - recovery percentage, which is the amount of the loan the borrower repaid before default
Credit Risk Example:
- Assume Bank ABC lends $5,000,000 to Company XYZ, which puts up $2,000,000 as collateral, resulting in an LGD of 60%
- Company XYZ repays $1,500,000 before economic conditions force it into default
- The EAD is $3,500,000, as Company XYZ repaid $1,500,000
- The PD is 70%, as Company XYZ repaid 30% of the loan
Therefore, the credit risk is:
70% (PD) x $3,500,000 (EAD) x 60% (LGD) = $1,470,000
Incorrect credit risk modeling by lenders can have catastrophic impacts. The 2008 global financial crisis is one credit risk example, when banks and rating agencies incorrectly, in some cases on purpose, rated credit risk. Sub-prime mortgages, ARM loans, CDS, and other associated derivatives resulted in credit risk concentration.
Rating agencies rated CDS AAA instead of junk, and investors piled into the US housing market, creating a bubble that burst in 2008, causing trillions of losses. Banks required taxpayer-funded government bailouts, and the global financial system is weaker today.
The Credit Risk Meaning Explained
When lenders evaluate a credit request, they usually begin by applying the 5 Cs of credit before conducting a sensitivity analysis.
The 5 Cs of credit are:
- Character - Evaluating the credit history of borrowers
- Capacity - Understanding if the borrower can service the credit
- Capital - The financial strength of the borrower
- Collateral - Essential for credit risk mitigation
- Conditions - The purpose of the requested credit, repayment terms, covenants, and other terms
The Difference Between Credit Risk, Market Risk, Default Risk, and Counterparty Risk
Market participants must not only understand the credit risk definition but know the different types of risks that may influence the credit market.
Credit Risk vs. Market Risk
Credit risk refers to a borrower defaulting on a loan, while market risk, or systematic risk, affects the entire financial market. Lenders cannot eliminate market risk through diversification, but hedge against it, while diversification can lower credit risk to acceptable levels.
Credit Risk vs. Default Risk
Credit risk is the risk a lender takes, while default risk is something the lender accepts, and the borrower could face. They have a similar outcome, and default risk is a sub-component of credit risk. A lender takes on credit risk each time it extends a loan, while default risk refers to a borrower failing to repay the principal or interest payments. Usually, a grace period exists for a borrower to make a payment before defaulting.
Credit Risk vs. Counterparty Risk
Credit risk is the risk a lender accepts when issuing loans, which could result in a loss. Counterparty risk refers to the inability of the counterparty to meet contractual obligations. Like default risk, it is a subcategory of credit risk.
Credit Risk Types
Understanding the credit risk definition includes knowing the five primary credit risk types, which assist in conducting an accurate credit risk assessment.
The five primary credit risk types are:
- Default risk - When a borrower cannot repay the loan amount or is late on a payment
- Concentration Risk - When a lender has too much exposure to a small group of borrowers or a specific industry group that can derail operations in the event of default
- Country risk - The potential of a sovereign country to default to political, economic, or social unrest
- Downgrade risk - When issued debt receives a downgrade, which increases borrowing costs for the entity, makes more debt harder to access, and sparks a downward spiral
- Institutional risk - When an institution fails to comply with rules and regulations or engages in contractual negligence
Credit Risk Assessment and Credit Risk Mitigation
Credit risk assessment and credit risk mitigation are tasks of risk management departments, and most lenders have dedicated teams for this task.
Credit risk assessment includes:
- Analyzing financial statements
- Evaluation of the gross margin percentage to gauge the sustainability of profits
- Review the history of borrowers, ensuring they have no previous defaults
- Understanding the industry, current economic conditions, monetary policy, and the outlook
- Using a credit report as a final reference
Credit risk mitigation consists of:
- Obtaining credit insurance
- Short payment terms to limit future uncertainties
- Requiring sufficient collateral
- Increase interest rates
- Request covenants to protect the lender in case the borrower breaches conditions
- Lend to low-risk borrowers
- Avoid credit risk concentration
- Offloading risk to a distributor
How to Use the Credit Rating, What is it, and Does it Matter?
With credit risk in banks gyrating with economic conditions and monetary policy and debt-driven consumerism the primary driver of consumer spending, which keeps the economy afloat, lenders rely heavily on credit ratings.
A credit rating for consumers is a numerical score that determines if a consumer qualifies for a loan, how much of a loan, at what interest rate, the duration, and required collateral. A higher score results in better credit conditions, while a lower score points towards a higher-risk borrower, where costs increase.
Corporate and government debt also has a credit score, usually expressed via an alphabetical score, but the same principle applies. It is worth noting that rating agencies often make mistakes. A credit rating for consumer loans is more accurate, and market participants should approach rating agencies with caution.
Credit Risk Conclusion
Credit risk is widespread in the global financial system, and risk management teams must conduct a proper credit risk analysis to avoid credit risk concentration. In an efficient financial system, credit risk remains minimal and manageable. Mistakes in the credit risk assessment can wreak havoc throughout the global system, as evident during the 2008 global financial crisis that began in the US housing market, the most regulated financial sector in the US.
FAQs
What causes credit risk?
Changes in economic conditions and monetary policy are primary causes of credit risk.
What is EAD in credit risk?
EAD refers to the potential loss a lender faces if a borrower defaults. For example, if a lender grants a $100,000 loan and the borrower repays $30,000 before defaulting, the EAD is $70,000.