Credit Risk: an Introduction

We will give an introduction to credit risk, presenting the main types of credit risk, the key components and measures of credit risk, discussing the different factors influencing it and ways to manage it.

Credit Risk: What is it?

Credit risk refers to the potential that a borrower or counterparty will fail to meet its obligations in accordance with terms of agreements, leading to a financial loss for the lender.

Example 1: credit risk on a debt

We consider a borrower, having some debt to a lender. If the borrower fails to make full payment of the debt in due time there will be a loss for the lender.

The borrower can be an individual, a company such as a corporate or a financial institution or a government, a sovereign or municipal borrower for instance.

The debt can be through a loan with a financial institution acting as the lender or through a bond with investors providing the capital.

Example 2: counterparty credit risk on a derivatives

Another example is the counterparty credit risk on derivatives. Let’s consider a swap between a bank A and a bank B, we assume that bank A has a positive mark-to-market while bank B has a negative one, if bank B default, then bank A is at risk on its positive mark-to-market, bank B might not be able to pay the total amount due to bank A.

Types of Credit Risk

There are different types of credit risks which can be classified in two categories, individual and portfolio credit risk.

Individual Credit Risk

• Default risk: the borrower or the counterparty fails to meet its payment obligations in due time.
• Exposure at risk: exposure at risk in case of default.
• Recovery risk: percentage of the exposure that will be recovered in case of default.
• Downgrade risk: higher perceived risk of default of the borrower, downgrade of its credit quality.
• Spread risk: risk of fluctuation of credit spread of the issuer affecting the market value of its debt instruments.

Portfolio Credit Risk

• Concentration risk: the risk arising from a lack of diversification within the credit portfolio, leading to higher exposure to a single borrower or sector.
• Country risk: the risk of political, economic, or social instability in a particular country affecting the credit portfolio.
• Sector risk: the risk that a specific industry or sector will perform poorly, adversely affecting the borrowers within that sector in the credit portfolio.
• Correlation risk: the risk that defaults or credit events are more likely to occur together than expected, often due to economic or financial linkage.
• Systemic risk: the risk of collapse in an entire financial system or entire market, potentially leading to severe economic consequences.

Credit Risk Measures

There are several key measures to quantify and manage credit risk.

Probability of Default

The probability of default PD is the likelihood that a borrower will fail to meet their debt obligations within a specified time period.

Exposure at Default

The Exposure at Default (EAD) is the total value a lender is exposed to at the time when a borrower or a counterparty defaults.

It depends on the type of instrument we consider.

For term loans it is simply the outstanding amount.

For off-balance sheet financing such as loan commitments, letters of credit or revolving facilities we can use of a credit conversion factor to estimate the additional amount of debt in the future.

For counterparty credit risk on derivatives, the exposure at default corresponds to the positive mark to market value + potential future exposures.

Loss Given Default

The Loss Given Default (LGD) is the percentage of an exposure that a lender expects to lose if a borrower defaults on a loan or a bond, after accounting for recoveries from collateral or other sources.

Several factors influence its value, including potential collaterals, guarantees, the type of instrument or the seniority of the debt.

Expected Loss and Unexpected Loss

The expected Loss (EL) is the average loss a lender expects to incur from defaults over a specific period, calculated as the product of the probability of default (PD), exposure at default (EAD), and loss given default (LGD).

EL = PD x EAD x LGD

If we consider credit losses of a portfolio over time, the expected loss is the average loss.

But there are risks of concentration, dependences between defaults, and losses can typically derive from the average when there is an economic crisis.

This potential loss that exceeds the expected loss in extreme adverse scenarios is the so-called unexpected loss (UL).

When modelling the credit risk of a portfolio, the expected loss is the average loss of the credit loss distribution. We fix a certain threshold, level of confidence, at 99.9% for example, the unexpected loss is the difference between the corresponding percentile of the distribution and the expected loss.

Credit Rating

Ratings help to measure the credit quality of a borrower, ranking borrowers from the ones with the highest quality and lowest credit risk to the ones with the lowest quality, very speculative with the highest credit risk.

But rating can change over time. A borrower can default, with a certain default probability but it can also be downgraded meaning a higher default risk of the borrower.

Rating transition matrices help to summarise all these possible movements, with probabilities of upgrade, downgrade or default for the different ratings with a specific period of time.

There are three main rating agencies Moody’s, S&P and Fitch that assess the creditworthiness of entities and securities.

Bond Prices and Spread Risk

Bond prices decrease when credit spreads widen. It becomes more expensive for issuer to borrow money while bond investors suffer MtM losses.

We simulate here a path of 10y credit spread and the price of a theoretical 10y zero coupon bond, the risk free interest being fixed at 5%.

Credit Risk Provisions and Capital

In order to cover for potential loan losses due to credit risk, the expected loss, financial institutions put some provisions, so that they can absorb losses from defaulted loans. 

They are also required to hold a minimum amount of capital, financial resources to protect against unexpected losses. This ensures the institution can absorb losses and continue operations during periods of financial stress, thereby protecting depositors and maintaining overall financial system stability.

Credit Risk Management

Effective credit risk management is key for financial institutions to ensure their stability and profitability. It includes:

• Credit Analysis, Scoring, Limit Monitoring: Assessing the creditworthiness of potential borrowers, Continuously monitoring.

• Stress Testing: simulations to evaluate how credit portfolios would evolve under adverse economic conditions.

• Diversification: diversify credit exposure across different borrowers, industries, and geographic regions.

• Collateral and Guarantees: Securing loans via collateral or guarantees to reduce potential losses.

• Credit Derivatives: Using financial instruments to transfer or mitigate credit risk.

Watch the Video

Save 10% on All Quant Next Courses with the Coupon Code: QuantNextBlog10

For students and graduates: We offer a 50% discount on all courses, please contact us if you are interested: contact@quant-next.com