Understanding Credit Risk and Key Concepts

In our previous post, we already discussed about the different types of risk in the banking industry. In this post, we are trying to cover the credit risk and its underlying concept along with its components. As credit risk is one of the most important aspects of BASEL regulations since the inception of BASEL.

Credit risk arises from failure of one party (Debtor) to meet its financial obligation to another party (Lender). Some of the basic examples are below:

• Party fails to repay its principal amount and interest or part of its to the lender.

• Downgrade risk: Credit risk arises due to decreases in the credit quality of a borrower. Let's say the bank B has sanctioned a 10 USD million loan to a corporate C under the assumption that it is good credit rating AAA (Investment Grade), however within a six-month its rating downgraded to BBB (non-Investment Grade). It's simply mean that chances of getting default for C has significantly increased.

• Counterparty Credit Risk: This risk arises when two or more than two party gets into a derivative contract (market trade) and party under the obligations is unable to fulfill it.

Credit risk associated with any exposure is driven by mainly three factors, what are the chances of default in a given time? what is the exposure at the time of default? and what is the loss given default or how much lender can recover in case of debtor gets default? In the credit risk language first question addresses the probability of default (PD), second addresses the exposure at default and last one is loss given default only.

Expected Credit Loss (ECL)=PD×LGD×EAD

Regardless of the approach and classification, the underlying concepts of PD, LGD, and EAD remain the same. Before diving into these metrics separately, it's crucial to understand the definition of default, which is subjective and varies across regions, industries, and the nature of the business involved.

For example, in retail banking, 90 days past due (DPD) is typically considered default for a counterparty. This 90 DPD threshold is also recommended by Basel for retail banking. However, during the COVID crisis, many central banks across the economies adjusted this criterion. Similarly, for a company operating in a business with a one-year cash cycle, a default definition of 365 DPD might be more appropriate due to the nature of its cash flow cycle.

In the upcoming post, we will be demystifying the concepts of PD, LGD and EAD in detail however basic definition is provided below.

Probability of Default, which is a key measure used in credit risk analysis. It represents the likelihood that a borrower (whether an individual, company, or government) will fail to meet their debt obligations within a specified time frame, typically one year.

Loss Given Default represents the proportion of an exposure that a lender is expected to lose if the borrower defaults.

Exposure at Default refers to the total value the lender is exposed to at the time of default. It represents the amount of credit extended to the borrower, including any undrawn commitments or facilities that may still be utilized before the default.