Credit Risk denotes a broad category of adverse financial outcomes arising from credit events (default, bankruptcy) associated with a legal entity reneging on its contractual obligations (typically for Payment)
Credit risk is a broad phenomenon as it applies to almost every conceivable economic activity. It is useful to enumerate some dimensions that can help narrow down more specific domains:
- The Legal Entities involved: These can range in size from
- The Financial Products or Contracts involved: These can be either explicit lending contracts, or other contractual relationships that may have embedded credit risk
- The Markets involved: Ranging from the Banking system, Fixed Income markets (Securitisation), Over-the-counter markets, Peer-to-peer lending etc.
Detailed analysis of credit risk factors requires narrowing down the domain as per the above dimensions and is captured in separate entries.
- It is generally considered that the Ability and Willingness to Pay captures at a high level the main underlying driver of credit risk
- Credit risk is generally considered to exhibity material dependency (See Default Correlation)
- Credit performance at the aggregate level can be seen as being driven by (and also driving) Macroeconomic Factors
Issues and Challenges
- Credit risk is highly context dependent (dynamic nature) and in general not amenable to rigid frameworks for either quantification or management
- Because of market / product segmentation some forms of credit risk are denoted as Counterparty Risk, although there is no intrinsic difference
- The active trading of credit obligations which is common in modern finance transforms credit risk into a form of Market Risk generating a number of more complicated risk phenomena
- Large scale credit risk manifestations (financial crises) can disrupt entire economies with potentially very adverse outcomes, even complete societal collapse
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