Credit Risk

Credit risk is the chance that a borrower or other counterparty fails to pay what it owes, in full and on time, leaving the lender with a loss. Banks face it on every loan, bond investors on every coupon, and ordinary businesses whenever they ship goods on credit terms. It is usually the largest single risk on a bank's balance sheet, and it is the reason lenders check repayment histories, ask for security and charge riskier borrowers higher interest.

Credit risk sits alongside market risk, liquidity risk and operational risk as one of the main categories that banks measure and hold capital against. It overlaps with counterparty risk, the narrower case of a trading partner defaulting before a derivative or securities deal is completed, and with settlement risk, where one side pays but the other never delivers. Capital rules for it are set internationally by the Basel Committee on Banking Supervision.

Lending money to a friend is the simplest picture of credit risk. You hand over cash today on a promise of repayment later, and you have to judge how likely it is that the friend will actually pay. If they have a steady job and have always paid back before, you worry less. If they are between jobs, you might lend less, ask to hold something valuable until they repay, or simply say no.

Banks make the same judgement thousands of times a day, only with more data and more formal rules. They look at income, past repayment records and what the borrower owns. They charge more interest to people and firms who seem more likely to miss payments, because a few of those loans will go bad and the extra interest from the others has to cover the losses. When a lender misjudges many loans at once, the losses can threaten the lender itself.

Lenders break credit risk into three building blocks. The probability of default is the chance that the borrower defaults within a set period, usually one year. Loss given default is the share of the exposure that is lost if default happens, after recoveries from security or bankruptcy proceedings. Exposure at default is the amount owed at the moment of failure, which for a credit line includes what the borrower is likely to draw before it fails. Multiplied together, they give the expected loss:

• $\text{EL}$ is the expected loss, in currency, over the period.
• $\text{PD}$ is the probability of default, written as a decimal.
• $\text{LGD}$ is the loss given default, as a share of the exposure.
• $\text{EAD}$ is the exposure at default.

Suppose a bank lends 1,000,000 dollars to a company with a one-year probability of default of 2 percent. The loan is secured on equipment, so the bank expects to lose 40 percent of the balance if the company fails. The expected loss is $0.02 \times 0.40 \times 1{,}000{,}000 = 8{,}000$ dollars a year. The bank builds that cost into the interest rate and its loan-loss provisions. Expected loss is only an average; capital is held against unexpected loss, the bad years when defaults run far above the norm.

Outside assessments help lenders and investors price credit risk. For individuals, credit bureaus gather repayment histories and turn them into a credit score; a weak score means higher rates or a refusal. For companies and governments that issue bonds, rating agencies such as S&P Global Ratings, Moody's and Fitch assign letter grades. Bonds rated BBB− by S&P and Fitch, or Baa3 by Moody's, and above are called investment grade; anything lower is high yield, often called junk. The extra yield a bond pays over a government bond of the same maturity is its credit spread, which widens when markets expect more defaults and narrows when confidence returns.

• Security. Taking collateral such as property, securities or cash lowers the loss given default, because the lender can sell it if the borrower fails.
• Limits and diversification. Banks cap how much they lend to any single borrower, industry or country, so that one failure cannot sink them.
• Covenants. Loan agreements oblige borrowers to keep financial ratios within agreed bounds, giving the lender early warning and the right to act.
• Credit derivatives. A credit default swap pays out if a named borrower defaults, letting a lender pass the risk to another party for a fee.
• Sale of loans. Through securitization, pools of loans are packaged into securities and sold to investors, moving the risk off the originating lender's books.

The 1988 Basel Capital Accord, known as Basel I, required internationally active banks to hold capital of at least 8 percent of risk-weighted assets, with weights set mainly by type of borrower. Basel II, published in 2004, allowed approved banks to use their own estimates of default probability, loss given default and exposure under the internal ratings-based approach. Basel III, agreed after the 2007–2009 crisis and finalised in December 2017, raised the amount and quality of regulatory capital and introduced an output floor so that capital calculated with internal models cannot fall below 72.5 percent of the standardised figure.

Accounting rules changed as well. IFRS 9, in force since 1 January 2018, and the current expected credit loss (CECL) standard in the United States require lenders to set aside provisions for losses they expect over the life of a loan, rather than waiting until a loss has actually been incurred. Critics argued the older incurred-loss approach recognised problems too late.

• Basel Framework (Bank for International Settlements)
• IFRS 9 Financial Instruments (IFRS Foundation)