Credit Risk – Meaning & Types
Credit Risk is the risk of loss due to a borrower's failure to repay a loan or meet contractual obligations. It is the oldest and most significant risk in banking.
Meaning
If you lend money to a friend, the risk that they won't pay you back is Credit Risk. In finance, it refers to the probability that a bond issuer or counterparty will Default.
Types of Credit Risk
1. Default Risk (Issuer Risk)
The risk that the borrower will go bankrupt and pay nothing (or only a fraction) of what they owe.
- Example: A company defaulting on its bonds.
2. Counterparty Risk
The risk that the other party in a derivative contract (e.g., Swap, Forward) will default before the trade is settled.
- Example: You bought a Call Option from Lehman Brothers, but they went bankrupt before you could exercise it.
3. Spread Risk (Downgrade Risk)
The risk that the borrower's credit rating will be downgraded (e.g., from AAA to BBB).
- Even if they don't default, the market value of their bond will drop because the yield spread widens.
4. Concentration Risk
The risk of having too much exposure to a single borrower, sector, or country.
- Example: A bank lending 50% of its capital to the Real Estate sector.
Lender's Perspective: For a bank, Credit Risk is the primary driver of capital requirements (Basel Accords). Banks must hold "Regulatory Capital" to buffer against potential defaults.
Loading quiz…