This phenomenon has traditionally been related to financial institutions. It can also be extended to companies, individuals, financial markets and organizations from other sectors. For example, when companies finance a product to their customers, when suppliers charge thirty days or when an investor buys a bond: they all have the risk of not receiving the amounts stipulated in the contract in the established time.
On the other hand, market risk (which also includes currency, price, volatility risk, etc.) has a systemic risk component, which is derived from the global market uncertainty that affects the more or more lesser degree to all existing assets in the economy and that cannot be completely eliminated.
Types of credit risk
As we have seen in previous lines, credit risk can occur both in financial institutions and in companies, markets or government agencies. It can also be supported by different economic agents, on which credit risk can be defined.
Credit risk on companies: this risk occurs when, after the installment of a product, the customer falls into default. To avoid such situations, what should be done is to hire an external service that is responsible for studying the credit risk of the customer who has requested the fractional payment.
Credit risk on natural persons: we all bear credit risk in many of our daily activities, from depositing our savings in a financial entity to working for others or carrying out larger investment operations. However, a series of legal measures that limit this credit risk of natural persons has been established. In the case of bank deposits, there is the Deposit Guarantee Fund (FGD), and in the case of non-payment of salaries, the Wage Guarantee Fund (FOGASA) has been created.
Credit risk on financial institutions: the financial product that is most exposed to credit risk is the loan, whether it is aimed at individuals or companies. For this reason, financial institutions usually carry out very thorough credit risk studies and include additional clauses in contracts such as the transfer of personal guarantees that, in case of default, cover the amount owed.
Fundamentally, there are two large credit risk groups in a financial company that depend directly on the counterparty. On the one hand, retail credit risk, which is the one that originates mostly from the financing activity of natural persons and SMEs, such as loans, credits or any financing activity related to them. On the other hand, there would be the wholesale credit risk, which is somewhat more complex by including the counterparty risk, which may come from financing activities or by the entity’s own activity when carrying out a sale or merger and acquisition operations.
Example of credit risk
Next, we will see a series of scenarios in which credit risk models are reproduced.
Default or default risk: this is the risk that is generated when the person to whom a loan is granted does not fulfill its obligations at the time of repayment.
Credit reduction risk: this type of risk is also known as migration or downgrade risk. It refers to the risk of rating agencies reducing the value of a credit.
Exposure risk: in this case, it refers to the risk that exists on the payments that the creditor must make in the future.
Credit spread risk: specifically, it is the risk that increases the profitability of a bond in relation to another that has the same expiration date.
Credit risk assessment: how is credit risk calculated?
Once we have fixed the concept of credit risk and the different types that exist in the financial market, we will see how to evaluate, in a very simple way, the credit risk of an operation.
For this, we will need to handle the following variables: the concept of expected loss, loss in case of default, exposure to default and the probability of default or default.
Probability of default (PD): The PD (Probability of default) is a measure of credit rating that is granted to a customer or contract with the objective of estimating the probability that there will be default on a one-year payment.
Exposure to default (EAD): EAD (Exposition at default) is another of the necessary indicators in the calculation of expected loss and capital. It is defined as the amount of debt that is pending payment at the moment in which the client breaches the contract.
- Loss in case of default (LGD): severity or LGD (Loss given default) is another key metric in the risk analysis and is defined as the percentage of risk exposure that is not expected to be recovered in case of default.
Thus, the credit risk indicators that we will use to generate our formula are the following:
Expected Loss = Probability of default or probability of default risk (PD) x Exposure to default or position value at the time of default risk (EAD) x Loss in case of Default (LGD).
Formula: PE = PD x EAD x LGD
Finally, we will see a practical example so that the calculation looks clearer. Imagine a person with a mortgage of 300,000 dollars, with an interest of 4% for 30 years. The risk department determines that there is a 2% chance of default at 30 years. In addition, it estimates a 60% recovery, which means that 40% will be lost. Therefore, applying our formula, the expected loss would be:
PE = 0.02 x 300,000 x 0.4 = $ 2,400.
Now you can get a more complete idea of what a credit risk entails, as well as credit model policies based on these risks. One way to minimize the impact it may have on your business organization or your financial investments is to anticipate a possible situation of default on the installment of a loan and mortgage to seek financing options that less affect your financial stability. A good option may be to apply for a personal credit online.
The advantage of these loans is that by carrying out a very simple procedure through the internet you can access an instant credit line of up to 5000 dollars. In the case of Good Credit, in addition, you can establish very flexible payment quotas that comfortably adapt to your financial situation or that of your company.