Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Another term for credit risk is default risk.

Investor losses include lost principal and interest Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, or, money earned by deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. The interest is, decreased cash flow Cash flow is a generic term used differently depending on the context. It may be defined by users for their own purposes. It can refer to actual past flows, or to projected future flows. It can refer to the total of all the flows involved or to only a subset of those flows. Subset terms include 'net cash flow', operating cash flow and free cash, and increased collection costs, which arise in a number of circumstances:

• A consumer does not make a payment due on a mortgage loan A mortgage loan is a loan secured by real property through the use of a document which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan. However, the word mortgage alone, in everyday usage, is most often used to mean mortgage loan, credit card A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services. The issuer of the card grants a line of credit to the consumer from which the user can borrow money for payment to a merchant or as a cash advance to the, line of credit A line of credit is any credit source extended to a business by a bank or financial institution. A line of credit may take several forms such as cash credit, overdraft, demand loan, export packing credit, term loan, discounting or purchase of commercial bills etc. It is like an account that can readily be tapped into if the need arises or not, or other loan
• A business does not make a payment due on a mortgage, credit card, line of credit, or other loan
• A business or consumer does not pay a trade invoice Trade credit exists when one firm provides goods or services to a customer with an agreement to bill them later, or receive a shipment or service from a supplier under an agreement to pay them later. It can be viewed as an essential element of capitalization in an operating business because it can reduce the required capital investment to operate when due
• A business does not pay an employee's earned wages A wage is a compensation, usually financial, received by workers in exchange for their labor when due
• A business or government bond In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals issuer does not make pay a coupon The coupon or coupon rate of a bond is the amount of interest paid per year expressed as a percentage of the face value of the bond. It is the interest rate that a bond issuer will pay to a bondholder or principal payment when due
• An insolvent insurance company Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the insurance; an insured or policyholder is the person or does not pay a policy obligation
• An insolvent bank Banking is generally a highly regulated industry, and government restrictions on financial activities by banks have varied over time and location. The current set of global bank capital standards are called Basel II. In some countries such as Germany, banks have historically owned major stakes in industrial corporations while in other countries won't return funds to a depositor
• A government grants bankruptcy Bankruptcy is a legally declared inability or impairment of ability of an individual or organization to pay its creditors. Creditors may file a bankruptcy petition against a business or corporate debtor in an effort to recoup a portion of what they are owed or initiate a restructuring. In the majority of cases, however, bankruptcy is initiated by protection to an insolvent A business may be 'cash flow insolvent' but 'balance sheet solvent' if it holds illiquid assets, particularly against short term debt that it cannot immediately realise if called upon to do so. Conversely, a business can have negative net assets showing on its balance sheet but still be cash flow solvent if ongoing revenue is able to meet debt consumer or business

Assessing credit risk

Significant resources and sophisticated programs are used to analyze and manage risk. 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 third party provided intelligence. Companies like Standard & Poor's Standard & Poor's is a division of McGraw-Hill that publishes financial research and analysis on stocks and bonds. It is well known for the stock market indexes, the US-based S&P 500, the Australian S&P/ASX 200, the Canadian S&P/TSX, the Italian S&P/MIB and India's S&P CNX Nifty, Moody's Moody's Corporation is the holding company for Moody's Investors Service, a Credit rating agency which performs international financial research and analysis on commercial and government entities. The company also ranks the credit-worthiness of borrowers using a standardized ratings scale. The company has a 40% share in the world credit rating, Fitch Ratings Fitch Ratings is an international credit rating agency dual-headquartered in New York City and London. It was one of the three Nationally Recognized Statistical Rating Organizations designated by the U.S. Securities and Exchange Commission in 1975, together with Moody's and Standard & Poor's, and Dun and Bradstreet The Dun & Bradstreet Corporation , headquartered in Short Hills, New Jersey, USA, is a provider of credit information on businesses and corporations. Often referred to as "D&B", the company is perhaps best known for its D-U-N-S (Data Universal Numbering System) identifiers assigned to over 150 million global companies provide such information for a fee.

Most lenders employ their own models (credit scorecards 'Credit scorecards' are mathematical models which attempt to provide a quantitive measurement of the likelihood that a customer will display a defined behavior with respect to their current or proposed credit position with a lender) to rank potential and existing customers according to risk, and then apply appropriate strategies. With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa. With revolving products such as credit cards and overdrafts, risk is controlled through the setting of credit limits. Some products also require security, most commonly in the form of property.

Credit scoring models also form part of the framework used by banks or lending institutions grant credit to clients. 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 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 contact (as outlined above).

Sovereign risk

Sovereign risk is the risk of a government becoming unwilling or unable to meet its loan obligations, or reneging on loans it guarantees.^[1] The existence of sovereign 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.^[2]

Five macroeconomic variables that affect the probability of sovereign debt Government debt is money (or credit) owed by any level of government; either central government, federal government, municipal government or local government. By contrast, annual government deficit refers to the difference between government receipts and spending in a single year. Debt of a sovereign government is called sovereign debt rescheduling are: ^[3]

• Debt service ratio In economics and government finance, debt service ratio is the ratio of debt service payments of a country to that country’s export earnings. A country's international finances are healthier when this ratio is low. The ratio is between 0 and 20% for most countries
• 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, variance of export revenue and domestic money supply growth. Frenkel, Karmann and Scholtens also argue that the likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity gains. Saunders argues that rescheduling can become more likely 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.^[4]

Counterparty risk

Counterparty risk, otherwise known as default risk Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Another term for credit risk is default risk, is the risk that an organization does not pay out on a credit derivative In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself. This entity is known as the reference entity and may be a corporate, a sovereign or, credit default swap A credit default swap is a swap contract in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default, credit insurance Credit insurance is a term used to describe both business credit insurance and consumer credit insurance, e.g., credit life insurance, credit disability insurance (a.k.a. credit accident and health insurance), and credit unemployment insurance, contract, or other trade or transaction when it is supposed to.^[5] Even organizations who think that they have hedged their bets by buying credit insurance of some sort still face the risk that the insurer will be unable to pay, either due to temporary liquidity In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value. Money, or cash on hand, is the most liquid asset. An act of exchange of a less liquid asset with a more liquid asset is called liquidation. Liquidity also refers both to a issues or longer term systemic issues.^[6]

Large insurers are counterparties to many transactions, and thus this is the kind of risk that prompts financial regulators to act, e.g., the bailout of insurer AIG American International Group, Inc. (NYSE: AIG) is an American insurance corporation. Its corporate headquarters are located in the American International Building in New York City. The British headquarters office is on Fenchurch Street in London, continental Europe operations are based in La Défense, Paris, and its Asian headquarters office is in.

On the methodological side, counterparty risk can be affected by wrong way risk, namely the risk that different risk factors be correlated in the most harmful direction. Including correlation between the portfolio risk factors and the counterparty default into the methodology is not trivial, see for example Brigo and Pallavicini^[7]

A good introduction can be found in a paper by Michael Pykhtin and Steven Zhu.^[8]

Mitigating credit risk

Lenders mitigate credit risk using several methods:

• Risk-based pricing: Lenders generally charge a higher interest Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, or, money earned by deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. The interest is rate to borrowers who are more likely to default, a practice called risk-based pricing Risk-based pricing is a methodology adopted by many lenders in the mortgage and financial services industries. It has been in use for many years as lenders try to measure loan risk in terms of interest rates and other fees. The interest rate on a loan is determined not only by the time value of money, but also by the lender's estimate of the. Lenders consider factors relating to the loan such as loan purpose Pertaining to mortgages and their risk based pricing factors, the loan purpose factor is sub-categorized by purchase, Rate & term refinance and cash-out refinance, credit rating A credit rating estimates the credit worthiness of an individual, corporation, or even a country. It is an evaluation made by credit bureaus of a borrower’s overall credit history. A credit rating is also known as an evaluation of a potential borrower's ability to repay debt, prepared by a credit bureau at the request of the lender . Credit, and loan-to-value ratio and estimates the effect on yield (credit spread In finance, a credit spread is the yield spread, or difference in yield between different securities, due to different credit quality. The credit spread reflects the additional net yield an investor can earn from a security with more credit risk relative to one with less credit risk. The credit spread of a particular security is often quoted in).
• Covenants: Lenders may write stipulations on the borrower, called covenants A loan covenant is a condition in a commercial loan or bond issue that requires the borrower to fulfill certain conditions or which forbids the borrower from undertaking certain actions, or which possibly restricts certain activities to circumstances when other conditions are met, into loan agreements:
  • Periodically report its financial condition
  • Refrain from paying dividends Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be paid to the shareholders as a dividend. Many corporations retain a, repurchasing shares In some countries, including the United States and the United Kingdom, corporations can buy back their own stock in a share repurchase, also known as a stock repurchase or share buyback. There has been a meteoric rise in the use of share repurchases in the U.S. in the past twenty years, from $5 billion in 1980 to $349 billion in 2005. A share, borrowing further, or other specific, voluntary actions that negatively affect the company's financial position
  • Repay the loan in full, at the lender's request, in certain events such as changes in the borrower's debt-to-equity ratio The debt-to-equity ratio is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as Risk, Gearing or Leverage. The two components are often taken from the firm's balance sheet or statement of financial position (so-called or interest coverage ratio
• Credit insurance and credit derivatives: Lenders and bond In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals holders may hedge In finance, a hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk. There are many specific financial vehicles to accomplish this, including insurance policies, forward contracts, swaps, options, their credit risk by purchasing credit insurance Credit insurance is a term used to describe both business credit insurance and consumer credit insurance, e.g., credit life insurance, credit disability insurance (a.k.a. credit accident and health insurance), and credit unemployment insurance, or credit derivatives In finance, a credit derivative is a derivative whose value is derived from the credit risk on an underlying bond, loan or other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself. This entity is known as the reference entity and may be a corporate, a sovereign or any other form of. These contracts the transfer risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is the credit default swap A credit default swap is a swap contract in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default.
• Tightening: Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a distributor Physical distribution is one of the four elements of the marketing mix. An organization or set of organizations (go-betweens) involved in the process of making a product or service available for use or consumption by a consumer or business user selling its products to a troubled retailer Retailing consists of the sale of goods or merchandise from a fixed location, such as a department store, boutique or kiosk, or by mail, in small or individual lots for direct consumption by the purchaser. Retailing may include subordinated services, such as delivery. Purchasers may be individuals or businesses. In commerce, a "retailer" may attempt to lessen credit risk by reducing payment terms from net 30 to net 15.
• Diversification: Lenders to a small number of borrowers (or kinds of borrower) face a high degree of unsystematic In finance, systematic risk, sometimes called market risk, aggregate risk, or undiversifiable risk, is the risk associated with aggregate market returns credit risk, called concentration risk Concentration risk is a banking term denoting the overall spread of a bank's outstanding accounts over the number or variety of debtors to whom the bank has lent money. This risk is calculated using a "concentration ratio" which explains what percentage of the outstanding accounts each bank loan represents. For example, if a bank has 5. Lenders reduce this risk by diversifying Diversification in finance is a risk management technique, related to hedging, that mixes a wide variety of investments within a portfolio. It is the spreading out of investments to reduce risks.Because the fluctuations of a single security have less impact on a diverse portfolio, diversification minimizes the risk from any one investment the borrower pool.
• Deposit insurance: Many governments establish deposit insurance Explicit deposit insurance is a measure implemented in many countries to protect bank depositors, in full or in part, from losses caused by a bank's inability to pay its debts when due. Deposit insurance systems are one component of a financial system safety net that promotes financial stability to guarantee bank deposits of insolvent banks. Such protection discourages consumers from withdrawing money when a bank is becoming insolvent, to avoid a bank run A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent. As a bank run progresses, it generates its own momentum, in a kind of self-fulfilling prophecy (or positive feedback): as more people withdraw their deposits, the likelihood of default increases, and this), and encourages consumers to holding their savings in the banking system instead of in cash.

See also

• Credit (finance) Credit is the provision of resources by one party to another party where that second party does not reimburse the first party immediately, thereby generating a debt, and instead arranges either to repay or return those resources (or material(s) of equal value) at a later date. It is any form of deferred payment. The first party is called a
• Default (finance)

Further reading

• Bluhm, Christian, Ludger Overbeck, and Christoph Wagner (2002). An Introduction to Credit Risk Modeling. Chapman & Hall/CRC. ISBN 978-1584883265.
• Damiano Brigo and Massimo Masetti (2006). Risk Neutral Pricing of Counterparty Risk, in: Pykhtin, M. (Editor), Counterparty Credit Risk Modeling: Risk Management, Pricing and Regulation. Risk Books. ISBN 1-904339-76-X.
• de Servigny, Arnaud and Olivier Renault (2004). The Standard & Poor's Guide to Measuring and Managing Credit Risk. McGraw-Hill. ISBN 978-0071417556.
• Darrell Duffie and Kenneth J. Singleton (2003). Credit Risk: Pricing, Measurement, and Management. Princeton University Press. ISBN 978-0691090467.
• Principles for the management of credit risk from the Bank for International Settlement

References

1. ^ Country Risk and Foreign Direct Investment. Duncan H. Meldrum (1999)
2. ^ Cary L. Cooper, Derek F. Channon (1998). The Concise Blackwell Encyclopedia of Management. ISBN 978-0631209119.
3. ^ Frenkel, Karmann and Scholtens (2004). Sovereign Risk and Financial Crises. Springer. ISBN 978-3540222484.
4. ^ Cornett, Marcia Millon and Saunders, Anthony (2006). Financial Institutions Management: A Risk Management Approach, 5th Edition. McGraw Hill. ISBN 978-0073046679.
5. ^ Investopedia. Counterparty risk. Retrieved 2008-10-06
6. ^ Tom Henderson. Counterparty Risk and the Subprime Fiasco. 2008-01-02. Retrieved 2008-10-06
7. ^ Brigo, Damiano and Andrea Pallavicini (2007). Counterparty Risk under Correlation between Default and Interest Rates. In: Miller, J., Edelman, D., and Appleby, J. (Editors), Numerical Methods for Finance. Chapman Hall. ISBN 158488925X. Related SSRN Research Paper
8. ^ A Guide to Modeling Counterparty Credit Risk, GARP Risk Review,July-August 2007 Related SSRN Research Paper

External links

• The Risk Management Association - leading industry organisation for credit risk professionals
• Defaultrisk.com - web site maintained by Greg Gupton with research and white papers on credit risk modelling.

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