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Credit risk
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{{Short description|Type of financial risk}} {{Financial risk types}} {{Basel II}} '''Credit risk''' is the chance that a [[borrower]] does not repay a [[loan]] or fulfill a loan obligation.<ref name="bcbs">{{cite journal |date=September 2000 |title=Principles for the Management of Credit Risk β final document |url=http://www.bis.org/publ/bcbs75.htm |journal=Basel Committee on Banking Supervision |publisher=BIS |access-date=13 December 2013 |quote=Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.}}</ref> For [[lenders]] the risk includes late or lost [[interest]] and [[principal sum|principal]] payment, leading to disrupted [[Cash flow|cash flows]] and increased [[Collection cost|collection costs]]. The loss may be complete or partial. In an [[Efficient-market hypothesis|efficient market]], higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as [[yield spread]]s can be used to infer credit risk levels based on assessments by [[Market participant|market participants]]. Losses can arise in a number of circumstances,<ref>[http://www.riskglossary.com/link/credit_risk.htm Risk Glossary: Credit Risk]</ref> for example: * A consumer may fail to make a payment due on a [[mortgage loan]], credit card, [[line of credit]], or other loan. * A company is unable to repay asset-secured fixed or [[floating charge]] debt. * A business or consumer does not pay a [[trade credit|trade invoice]] when due. * A business does not pay an employee's earned wages when due. * A business or government [[Bond (finance)|bond]] issuer does not make a payment on a [[Coupon (bond)|coupon]] or principal payment when due. * An [[Insolvency|insolvent]] insurance company does not pay a [[Insurance policy|policy]] obligation. * An insolvent bank will not return funds to a depositor. * A government grants [[bankruptcy]] protection to an insolvent consumer or business. To reduce the lender's credit risk, the lender may perform a [[credit check]] on the prospective borrower, may require the borrower to take out appropriate insurance, such as [[mortgage insurance]], or seek [[Collateral (finance)|security]] over some assets of the borrower or a [[guarantee]] from a third party. The lender can also take out insurance against the risk or on-sell the debt to another company. In general, the higher the risk, the higher will be the [[interest rate]] that the debtor will be asked to pay on the debt. Credit risk mainly arises when borrowers are unable or unwilling to pay. == Types == A credit risk can be of the following types:<ref>[https://www.unicreditgroup.eu/en/investors/risk-management/credit.html Credit Risk Classification] {{webarchive|url=https://web.archive.org/web/20130927181311/https://www.unicreditgroup.eu/en/investors/risk-management/credit.html |date=2013-09-27 }}</ref> * [https://www.investopedia.com/terms/d/defaultrisk.asp#:~:text=Default%20risk%20is%20the%20risk,all%20forms%20of%20credit%20extensions. Credit default risk] β The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or the debtor is more than 90 days past due on any material credit obligation; default risk may impact all credit-sensitive transactions, including loans, securities and [[Derivative (finance)|derivatives]]. * [[Concentration risk]] β 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]] β The risk of loss arising from a sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations ([[Sovereign credit risk|sovereign risk]]); this type of risk is prominently associated with the country's macroeconomic performance and its political stability. == Assessment == {{Main|Credit analysis|Consumer credit risk}} Significant resources and sophisticated programs are used to analyze and manage risk.<ref>[http://www.bis.org/publ/bcbs126.htm BIS Paper:Sound credit risk assessment and valuation for loans]</ref> 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 the third party provided intelligence. Nationally recognized statistical rating organizations provide such information for a fee. For large companies with liquidly traded [[Corporate bond|corporate bonds]] or [[Credit default swap|Credit Default Swaps]], bond [[Yield spread|yield spreads]] and credit default swap spreads indicate market participants assessments of credit risk and may be used as a reference point to price loans or trigger collateral calls. Most lenders employ their models ([[credit scorecards]]) to rank potential and existing customers according to risk, and then apply appropriate strategies.<ref>{{Cite web |url=http://www.crc.man.ed.ac.uk/conference/archive/2007/papers/huang-and-scott.pdf |title=Huang and Scott: Credit Risk Scorecard Design, Validation and User Acceptance |access-date=2011-09-22 |archive-url=https://web.archive.org/web/20120402191742/http://www.crc.man.ed.ac.uk/conference/archive/2007/papers/huang-and-scott.pdf |archive-date=2012-04-02 |url-status=dead }}</ref> With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher-risk customers and vice versa.<ref>[http://www.investopedia.com/terms/r/risk-based_mortgage_pricing.asp Investopedia: Risk-based mortgage pricing]</ref><ref>{{Cite web |url=http://www.crc.man.ed.ac.uk/conference/archive/2003/presentations/edelman.pdf |title=Edelman: Risk-based pricing for personal loans |access-date=2011-09-22 |archive-url=https://web.archive.org/web/20120402191751/http://www.crc.man.ed.ac.uk/conference/archive/2003/presentations/edelman.pdf |archive-date=2012-04-02 |url-status=dead }}</ref> With revolving products such as credit cards and overdrafts, the risk is controlled through the setting of credit limits. Some products also require [[Collateral (finance)|collateral]], usually an asset that is pledged to secure the repayment of the loan.<ref>Berger, Allen N., and Gregory F. Udell. "Collateral, loan quality and bank risk."Journal of Monetary Economics 25.1 (1990): 21β42.</ref> Credit scoring models also form part of the framework used by banks or lending institutions to grant credit to clients.<ref name="JarrowLando1997">{{cite journal|last1=Jarrow|first1=R. A.|last2=Lando|first2=D.|last3=Turnbull|first3=S. M.|s2cid=154117131|title=A Markov Model for the Term Structure of Credit Risk Spreads|journal=Review of Financial Studies|volume=10|issue=2|year=1997|pages=481β523|issn=0893-9454|doi=10.1093/rfs/10.2.481|doi-access=}}</ref> 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 [[Accounting liquidity|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).<ref>Altman, Edward I., and Anthony Saunders. "Credit risk measurement: Developments over the last 20 years." Journal of Banking & Finance 21.11 (1997): 1721β1742.</ref><ref>Mester, Loretta J. "What's the point of credit scoring?." Business review 3 (1997): 3β16.</ref> === Sovereign risk === [[Sovereign credit risk]] is the risk of a government being unwilling or unable to meet its loan obligations, or reneging on loans it guarantees. Many countries have faced sovereign risk in the [[late-2000s global recession]]. The existence of such 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.<ref>{{cite book | author1 = Cary L. Cooper | author2 = Derek F. Channon | title = The Concise Blackwell Encyclopedia of Management | year = 1998 | publisher = Wiley | isbn = 978-0-631-20911-9 | url-access = registration | url = https://archive.org/details/conciseblackwell0000unse }}</ref> Five macroeconomic variables that affect the probability of [[sovereign debt]] rescheduling are:<ref name="sovrisk">{{cite book | author = Frenkel, Karmann and Scholtens| title = Sovereign Risk and Financial Crises| year = 2004 |publisher = Springer|isbn = 978-3-540-22248-4}}</ref> * [[Debt service ratio]] * [[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, the variance of export revenue and domestic money supply growth.<ref name="sovrisk"/> The likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity gains. Debt rescheduling likelihood can increase 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.<ref name="Saunders">{{cite book |author1=Cornett, Marcia Millon |author2=Saunders, Anthony | title = Financial Institutions Management: A Risk Management Approach, 5th Edition | year = 2006 | publisher = McGraw-Hill | isbn = 978-0-07-304667-9 |title-link=Risk management }}</ref> === Counterparty risk === A counterparty risk, also known as a [[settlement risk]] or '''counterparty credit risk''' ('''CCR'''), is a risk that a [[counterparty]] will not pay as obligated on a [[bond (finance)|bond]], [[derivative (finance)|derivative]], [[insurance policy]], or other contract.<ref>Investopedia. [http://www.investopedia.com/terms/c/counterpartyrisk.asp Counterparty risk]. Retrieved 2008-10-06</ref> Financial institutions or other transaction counterparties may [[hedge (finance)|hedge]] or take out [[credit derivative|credit insurance]] or, particularly in the context of derivatives, require the posting of collateral. Offsetting counterparty risk is not always possible, e.g. because of temporary liquidity issues or longer-term systemic reasons.<ref>Tom Henderson. [http://seekingalpha.com/article/58780-counterparty-risk-and-the-subprime-fiasco Counterparty Risk and the Subprime Fiasco]. 2008-01-02. Retrieved 2008-10-06</ref> Further, counterparty risk increases due to positively correlated risk factors; accounting for this correlation between portfolio risk factors and counterparty default in risk management methodology is not trivial.<ref>{{cite book |author1=Brigo, Damiano |author2=Andrea Pallavicini| title = Counterparty Risk under Correlation between Default and Interest Rates. In: Miller, J., Edelman, D., and Appleby, J. (Editors), Numerical Methods for Finance| year = 2007 |publisher = Chapman Hall|isbn = 978-1-58488-925-0}}[http://ssrn.com/abstract=926067 Related SSRN Research Paper]</ref><ref>{{Citation |last1=Orlando |first1=Giuseppe |title=Distributions Commonly Used in Credit and Counterparty Risk Modeling |date=2021-10-28 |url=https://www.worldscientific.com/doi/10.1142/9789811252365_0001 |work=Modern Financial Engineering |volume=2 |pages=3β23 |series=Topics in Systems Engineering |publisher=WORLD SCIENTIFIC |doi=10.1142/9789811252365_0001 |isbn=978-981-12-5235-8 |access-date=2022-04-10 |last2=Bufalo |first2=Michele |last3=Penikas |first3=Henry |last4=Zurlo |first4=Concetta|s2cid=245970287 |url-access=subscription }}</ref> The [[capital requirement]] here is calculated using SA-CCR, the [[standardized approach (counterparty credit risk)|standardized approach for counterparty credit risk]]. This framework replaced both non-internal model approaches - Current Exposure Method (CEM) and Standardised Method (SM). == Mitigation == Lenders mitigate credit risk in a number of ways, including: * '''Risk-based pricing''' β Lenders may charge a higher [[interest rate]] to borrowers who are more likely to default, a practice called '''[[risk-based pricing]]'''. Lenders consider factors relating to the loan such as [[loan purpose]], [[credit rating]], and [[loan-to-value ratio]] and estimates the effect on yield ([[credit spread (bond)|credit spread]]). * '''Covenants''' β Lenders may write stipulations on the borrower, called '''[[loan covenant|covenants]]''', into loan agreements, such as:<ref>[http://moneyterms.co.uk/debt_covenants/ Debt covenants]</ref> ** Periodically report its financial condition, ** Refrain from paying [[dividend]]s, [[share repurchase|repurchasing shares]], borrowing further, or other specific, voluntary actions that negatively affect the company's financial position, and ** 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 [[times interest earned|interest coverage ratio]]. * '''Credit insurance''' and '''credit derivatives''' β Lenders and [[bond (finance)|bond]] holders may [[Hedge (finance)#Hedging credit risk|hedge]] their credit risk by purchasing '''credit insurance''' 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 swap]]'''. * '''Tightening''' β Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a [[Distribution (business)|distributor]] selling its products to a troubled [[retailer]] may attempt to lessen credit risk by reducing payment terms from ''net 30 '' to ''net 15''. * '''Diversification''' β Lenders to a small number of borrowers (or kinds of borrower) face a high degree of [[systematic risk#Unsystematic risk|unsystematic]] credit risk, called '''[[concentration risk]]'''.<ref>[http://www.businessinsider.com/mba-mondays-diversification-2010-6 MBA Mondays:Risk Diversification]</ref> Lenders reduce this risk by [[Diversification (finance)|diversifying]] the borrower pool. * '''Deposit insurance''' β Governments may establish '''[[deposit insurance]]''' to guarantee bank deposits in the event of insolvency and to encourage consumers to hold their savings in the banking system instead of in cash. == Related Initialisms == * '''ACPM''' Active credit portfolio management <ref>[[Moody's Analytics]] (2008). [https://www.moodysanalytics.com/-/media/whitepaper/before-2011/03-25-08-a-brief-history-of-active-credit-portfolio-management.pdf A Brief History of Active Credit Portfolio Management]</ref> * '''CCR''' [[Counterparty credit risk|Counterparty Credit Risk]] * '''CE''' [[Credit Exposure]] * '''CVA''' [[Credit valuation adjustment]] * '''DVA''' Debit Valuation Adjustment β see [[XVA]] * '''EAD''' [[Exposure at default]] * '''EE''' [[Potential_future_exposure#Expected_exposure|Expected Exposure]] * '''EL''' [[Expected loss]] * '''JTD''' - Jump-to-default, where the [[Credit_default_swap#Risk|reference entity suddenly defaults]] * '''LGD''' [[Loss given default]] * '''PD''' [[Probability of default]] * '''PFE''' [[Potential future exposure]] * '''SA-CCR''' [[Standardized approach (counterparty credit risk)|The Standardised Approach to Counterparty Credit Risk]] * '''VAR''' [[Value at risk]] == See also == * [[Credit (finance)]] * [[Credit spread curve]] * [[Criticism of credit scoring systems in the United States]] * [[CS01]] * [[Default (finance)]] * [[Distressed securities]] * [[JarrowβTurnbull model]] * [[KMV model]] * [[Merton model]] == References == {{Reflist|30em}} == Further reading == * {{cite book |author1=Bluhm, Christian |author2=Ludger Overbeck |author3=Christoph Wagner |name-list-style=amp | title = An Introduction to Credit Risk Modeling | year = 2002 |publisher = Chapman & Hall/CRC | isbn= 978-1-58488-326-5}} * {{cite book | author = [[Damiano Brigo]] and Massimo Masetti | title = Risk Neutral Pricing of Counterparty Risk, in: Pykhtin, M. (Editor), Counterparty Credit Risk Modeling: Risk Management, Pricing and Regulation | year = 2006 |publisher = Risk Books|isbn = 978-1-904339-76-2}} * {{cite book |author1 = Orlando, Giuseppe |author2=Bufalo Michele |author3=Penikas Henry |author4= Zurlo Concetta | title = Modern Financial Engineering: Counterparty, Credit, Portfolio and Systemic Risks | year = 2022 |publisher = World Scientific|isbn = 978-981-125-235-8 }} * {{cite book |author1=de Servigny, Arnaud |author2=Olivier Renault | title = The Standard & Poor's Guide to Measuring and Managing Credit Risk | year = 2004 |publisher = McGraw-Hill | isbn=978-0-07-141755-6}} * {{cite book | author = [[Darrell Duffie]] and [[Kenneth J. Singleton]] | title = Credit Risk: Pricing, Measurement, and Management | year = 2003 |publisher = Princeton University Press| isbn=978-0-691-09046-7 }} * [http://www.bis.org/publ/bcbs75.htm Principles for the management of credit risk] from the Bank for International Settlements == External links == *[https://www.springer.com/gp/book/9783030428655 Bank Management and Control], Springer Nature β Management for Professionals, 2020 *[https://www.crif.in/products-and-services/predictive-analytics-scorecards Credit Risk Modelling], - information on credit risk modelling and decision analytics *[http://ssrn.com/abstract_id=1032522 A Guide to Modeling Counterparty Credit Risk] β SSRN Research Paper, July 2007 *[https://web.archive.org/web/20090804080317/http://defaultrisk.com/ Defaultrisk.com] β research and white papers on credit risk modelling *[http://www.risk.net/type/technical-paper/source/journal-of-credit-risk/ The Journal of Credit Risk] publishes research on credit risk theory and practice. *[https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3206607 Soft Data Modeling Via Type 2 Fuzzy Distributions for Corporate Credit Risk Assessment in Commercial Banking] SSRN Research Paper, July 2018 {{Financial risk}} {{Authority control}} [[Category:Credit risk| ]] [[Category:Actuarial science]] [[Category:Banking infrastructure]] [[Category:Financial law]]
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