Credit Risk

Any time one party extends money or value on the promise of repayment, credit risk arises. It covers loans and bonds, trade credit, guarantees given, and the settlement of derivatives. Its parts are usually described as the probability that the borrower defaults, the fraction of the exposure that is lost in that event, and the size of the exposure at the time. Lenders manage it by assessing the borrower before lending, setting limits, taking collateral or guarantees, pricing for risk, spreading exposure, and watching accounts after the loan is made. Accounting rules require provisions for expected losses, and prudential rules require capital for unexpected ones. Credit risk is the largest risk for most banks and also matters to any firm that sells on credit. Credit committees weigh it against the capital available to absorb losses when they set lending limits and provisions.

Five million is lent to a mid-sized wholesaler. Two years on, the wholesaler loses a large customer, delays payments to suppliers and misses a loan instalment. The bank moves the account to its watchlist, reviews the collateral, and sets aside a provision. If the retailer defaults, the bank's loss will be the unpaid balance less whatever it recovers from selling the pledged stock.