creditrisk

Credit risk is the risk of loss arising from a borrower or counterparty failing to meet contractual obligations, or from a deterioration in credit quality that reduces the value of financial assets. It affects loans, bonds, trade finance, derivatives, and other financial instruments, and can propagate through markets and institutions through interconnected exposures.

Exposures to credit risk include default risk, which occurs when a borrower misses payments or defaults; concentration risk, where large exposures to a single counterparty or sector amplify losses; country risk, settlement risk, and downgrade risk. The primary concern is the potential mismatch between contractual cash flows and actual receipts, which can erode earnings and capital.

Measurement relies on quantitative concepts such as probability of default (PD), loss given default (LGD), and exposure at default (EAD). The expected credit loss (ECL) framework, used under IFRS 9, requires recognizing credit losses over the life of an instrument. Banks often use internal rating systems or external credit ratings to estimate PDs and combine them with LGD and EAD for capital calculations and pricing.

Modeling approaches include structural models (for example, Merton-type models), reduced-form models, and credit scoring for individuals and small businesses. Risk management combines quantitative assessment with qualitative factors such as borrower behavior, covenants, and collateral. Institutions employ underwriting standards, risk limits, monitoring, and provisions to mitigate losses.

Mitigation strategies include diversification, collateral, seniority, netting, credit enhancements, and, where appropriate, credit protection through instruments like credit default swaps or securitization. Regulatory frameworks such as Basel II/III/IV impose capital charges for credit risk and recognition rules for risk mitigants; IFRS 9 requires ECL-based impairment accounting. Effective credit risk management relies on data quality, model validation, governance, and ongoing monitoring of macroeconomic conditions and borrower behavior.