Credit risk is risk due to uncertainty
in a counterparty's (also called an obligor's
or credit's) ability to meet its obligations. Because there are
many types of counterparties—from individuals to sovereign governments—and
many different types of obligations—from auto loans to
risk takes many forms. Institutions manage it in different ways.
In assessing credit
risk from a single counterparty, an institution must consider three issues:
probability: What is the likelihood that the counterparty will
default on its obligation either over the life of the obligation or over
some specified horizon, such as a year? Calculated for a one-year horizon,
this may be called the expected
In the event of a default, how large will the outstanding obligation be
when the default occurs?
In the event of a default, what fraction of the exposure may be recovered
through bankruptcy proceedings or some other form of settlement?
When we speak of the credit quality
of an obligation, this refers generally to the counterparty's ability to
perform on that obligation. This encompasses both the obligation's default
probability and anticipated recovery rate.
To place credit exposure and credit quality in
perspective, recall that every risk comprise two
elements: exposure and uncertainty. For credit risk, credit exposure
represents the former, and credit quality represents the latter.
For loans to individuals or small businesses, credit quality is
typically assessed through a process of credit
scoring. Prior to extending credit, a bank or other lender will
obtain information about the party requesting a loan. In the case of a
bank issuing credit cards, this might include the party's annual income,
existing debts, whether they rent or own a home, etc. A standard formula
is applied to the information to produce a number, which is called a
credit score. Based upon the credit score, the lending institution will
decide whether or not to extend credit. The process is formulaic and
Many forms of credit risk—especially those associated with larger
institutional counterparties—are complicated, unique or are of such a
nature that that it is worth assessing them in a less formulaic manner.
The term credit analysis is used to
describe any process for assessing the credit quality of a counterparty.
While the term can encompass credit scoring, it is more commonly used to
refer to processes that entail human judgment. One or more people, called
credit analysts, will review
information about the counterparty. This might include its balance sheet,
income statement, recent trends in its industry, the current economic
environment, etc. They may also assess the exact nature of an obligation.
For example, secured debt generally has higher credit quality than does
subordinated debt of the same issuer. Based upon this analysis, the credit
assign the counterparty (or the specific obligation) a
which can be used for making credit decisions.
Many banks, investment managers and insurance companies hire their own credit
analysts who prepare credit ratings for internal use. Other
firms—including Standard & Poor's, Moody's and Fitch—are in the business
of developing credit ratings for use by investors or other third parties. Institutions that have publicly traded debt
hire one or more of them to prepare credit ratings for their debt. Those
credit ratings are then distributed for little or no charge to investors.
Some regulators also develop credit ratings. In the United States, the
National Association of Insurance Commissioners publishes credit ratings
that are used for calculating capital charges for
bond portfolios held by
Exhibit 1 indicates the system of credit ratings employed by Standard &
Poor's. Other systems are similar.
quality—Extremely reliable with regard to financial obligations.
credit quality—Very reliable.
susceptible to economic conditions—still good credit quality.
rating in investment grade.
necessary—Best sub-investment credit quality.
to changes in economic conditions—Currently showing the ability
to meet its financial obligations.
vulnerable to nonpayment—Dependent on favorable economic
vulnerable to a payment default.
||Close to or
already bankrupt—payment on the obligation currently continued.
default on some financial obligation has actually occurred.
This is the system of credit ratings
Standard & Poor's applies to bonds. Ratings can be modified with
+ or – signs, so a AA– is a higher rating than is an A+ rating. With
such modifications, BBB– is the lowest investment grade rating. Other credit rating systems are
similar. Source: Standard & Poor's.
The manner in which credit exposure is assessed is highly
dependent on the nature of the obligation. If a bank has loaned money to a
firm, the bank might calculate its credit exposure as the outstanding
balance on the loan. Suppose instead that the bank has extended a line of credit to a
firm, but none of the line has yet been drawn down. The
immediate credit exposure is zero, but this doesn't reflect the fact that
the firm has the right to draw on the line of credit. Indeed, if the firm
gets into financial distress, it can be expected to draw down on the
credit line prior to any bankruptcy. A simple solution is for the bank to
consider its credit exposure to be equal to the total line of credit.
However, this may overstates the credit exposure. Another approach
would be to calculate the credit exposure as being some fraction of the
total line of credit, with the fraction determined based upon an
analysis of prior experience with similar credits.
Credit risk modeling is a concept that broadly encompasses
any algorithm-based methods of assessing credit risk. The term encompasses
credit scoring, but it is more frequently used to describe the use of
asset value models and
intensity models in several contexts.
traditional credit analysis;
used by financial engineers to
value credit derivatives; and
extended as portfolio credit risk
measures used to analyze the credit risk of entire portfolios of obligations
to support securitization,
or regulatory purposes.
Derivative instruments represent contingent obligations, so they entail
credit risk. While it is possible
to measure the mark-to-market credit exposure of derivatives based upon
their current market values, this
metric provides an incomplete picture.
For example, many derivatives, such as
swaps, have a market value
of zero when they are first entered into. Mark-to-market exposure—which
is based only on current market values—does not capture the potential for
market values to increase over time. For that purpose some probabilistic
metric of potential credit exposure
must be used.
There are many ways that credit risk can be managed or mitigated. The
first line of defense is the use of credit scoring or credit analysis to
avoid extending credit to parties that entail excessive credit risk.
Credit risk limits are widely used. These
generally specify the maximum exposure a firm is willing to take to a
counterparty. Industry limits or country limits may also be established to
limit the sum credit exposure a firm is willing to take to counterparties
in a particular industry or country. Calculation of exposure under such
limits requires some form of credit
risk modeling. Transactions may be structured to
include collateralization or various
credit enhancements. Credit risks can
be hedged with credit derivatives.
Finally, firms can hold capital
against outstanding credit exposures.
bond Securitized debt.
A bond issued by a corporation.
A derivative instrument designed to transfer credit risk from one
party to another.
Any methodology that reduces the credit risk of a transaction with
default model A type of model that assess the likelihood of default by
risk management Practices by which a firm optimizes the
manner in which it takes financial risk.
interest rate spreads
Risk from uncertainty due to legal actions or uncertainty in the applicability
or interpretation of contracts, laws or regulations.
Risk due to uncertain liquidity.
market risk Exposure to the uncertain market value of a portfolio.
risk Risk due to human error, systems failure or external
portfolio credit risk
Credit risk associated with a portfolio of obligations, typically
of multiple obligors.
pre-settlement risk Credit risk of default on a derivative instrument
prior to final settlement.
risk Comprises two components:
uncertainty and exposure.
A limit placed upon risk taking activity for the purpose of
avoiding excessive risk.
settlement risk A form of credit risk that arises at the settlement
of a transaction.
For a sophisticated overview of credit
risk, see Caouette et al (1998).
Ganguin and Bilardello (2005)
is an excellent introduction to credit analysis for corporate
bonds. Glantz (2003)
is an excellent book on credit risk in bank commercial lending.
With credit risk models starting to supplant traditional credit
analysis, and regulators increasingly invoking agency credit
ratings in their regulations, there is much controversy
surrounding the use of credit ratings. For insightful discussions
of current trends, see Ong (2003).
For detailed descriptions of asset value models and intensity
models, see Bluhm et al (2002)
and Duffie and Singleton (2003),
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