Credit risk is the possibility that a borrower or counterparty will fail to meet financial obligations according to agreed terms, causing losses to a creditor. It arises in lending, debt investment, guarantees, payment settlement, and other financial transactions. Although especially important to banks, it also affects investors and businesses extending credit to customers. Assessment concerns both individual obligations and the combined exposure of a credit portfolio. (bis.org)
Sources and forms
The most direct form is default risk: the possibility that promised principal, interest, or other payments will not be received in full or on time. Credit exposure extends beyond outstanding loans to bonds, interbank transactions, trade financing, undrawn commitments, and guarantees. These off-balance-sheet arrangements may create losses even when no funded loan initially exists. (bis.org)
Counterparty credit risk arises particularly in derivatives and securities financing transactions. Exposure can change with market prices rather than remain equal to a fixed amount originally advanced. Credit deterioration may also reduce a transaction’s value before default occurs; credit valuation adjustment incorporates the effect of counterparty default risk into valuation. Settlement arrangements introduce additional exposure when one party delivers funds or assets before receiving the corresponding payment. (federalreserve.gov)
Credit risk interacts with, but is distinct from, liquidity risk and market risk. Supervisory assessment therefore considers contractual terms, maturity, potential market movements, collateral, guarantees, and borrower credit quality together rather than treating default probability as the sole measure of risk. (bis.org)
Measurement and expected loss
A widely used framework separates three components:
- Probability of default (PD): the likelihood of default over a specified horizon.
- Loss given default (LGD): the proportion of exposure lost conditional on default, reflecting recoveries and associated costs.
- Exposure at default (EAD): the amount exposed when default occurs.
For non-defaulted exposures under the Basel internal ratings-based framework, expected loss as a monetary amount is calculated as:
The horizon and estimation conventions matter: Basel corporate, sovereign, and bank PD inputs generally use a one-year horizon, while accounting measurements may require lifetime estimates. (bis.org)
For illustration, a $1 million exposure with a one-year PD of 2% and LGD of 40% has an expected loss of $8,000 under this simplified calculation. This is an expected value, not a forecast that precisely $8,000 will be lost on that particular obligation.
Expected loss must be distinguished from unexpected loss: adverse outcomes exceeding the anticipated average. The Basel framework treats expected losses and provisions separately from risk-weighted capital requirements designed to address unexpected losses. Consequently, two portfolios with similar expected losses may require different assessments of severe outcomes and concentration. (bis.org)
Assessment and portfolio effects
Credit assessment examines repayment capacity using financial condition, cash flows, payment history, contractual structure, and economic conditions. Credit ratings and internal risk grades organize exposures by creditworthiness. Borrower grades principally describe default risk, whereas transaction-specific assessment considers collateral, seniority, and product characteristics that affect loss severity. Ratings and estimates require continuing review as circumstances change. (bis.org)
Portfolio risk depends on more than the number of borrowers. Concentration risk arises when substantial exposures share a borrower, affiliated group, industry, or other common sensitivity. Correlation between exposures can produce simultaneous deterioration, limiting the protection offered by apparent diversification. Identifying correlated pools is therefore an important part of portfolio analysis. (occ.treas.gov)
A related problem is wrong-way risk, in which exposure to a counterparty increases as that counterparty’s probability of default rises. It can arise from a transaction’s specific structure or from common market factors. For example, accepting a counterparty affiliate’s securities as collateral can connect the value of protection to the financial condition of the counterparty group. (federalreserve.gov)
Management and mitigation
Credit risk management combines underwriting standards, approval authorities, exposure limits, monitoring, independent controls, and procedures for deteriorating credits. Pricing and contractual terms are assessed against expected returns and potential losses. Interest rates, restrictive covenants, guarantees, and collateral influence the risk–return relationship, but do not replace assessment of repayment capacity. (bis.org)
Mitigation can reduce exposure or improve recovery, yet its effectiveness depends on legal enforceability, valuation, and the financial strength of protection providers. Stress testing examines adverse scenarios, including changes in borrower condition, market exposures, and concentration. It complements ordinary estimates by exploring circumstances in which historical relationships or recovery assumptions may fail. (bis.org)
Capital regulation and accounting
The Basel Accords provide international standards for credit-risk capital measurement. The framework includes standardized approaches and, subject to supervisory approval and restrictions, internal ratings-based approaches. Bank capital provides loss-absorbing capacity; accounting allowances instead adjust asset values for expected credit losses. Regulatory and accounting estimates serve different purposes and need not coincide. (bis.org)
Under IFRS 9, the general impairment model distinguishes twelve-month expected credit losses from lifetime losses, with lifetime recognition required following a significant increase in credit risk. Twelve-month losses mean lifetime cash shortfalls associated with defaults possible during the next twelve months—not merely payments expected to be missed during that period. (ifrs.org)
Under United States accounting rules, Current Expected Credit Losses (CECL) generally measures lifetime expected losses for covered amortized-cost assets, including loans and held-to-maturity debt securities. Estimates draw on historical experience, current conditions, and reasonable, supportable forecasts, making the quality of data, assumptions, documentation, and validation central to reported allowances. (fdic.gov)