Credit Risk

From Open Risk Manual

Definition

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 (for payment)

Dimensions

Credit risk is a very broad phenomenon as it applies to practically almost every conceivable economic activity. It is useful to enumerate some dimensions that can help narrow down more specific domains

  • Legal Entities involved. These can range in size from any physical person legally able to enter into contractual relationships, to supranational entities representing very large populations
  • Contracts involved. These can be either explicit lending contracts, or other contractual relationships that may have embedded credit risk
  • Products and Markets involved. Ranging from the Banking system, Fixed Income markets (Securitisation), Over-the-counter markets, Peer-to-peer lending etc.

Factors

Detailed analysis of credit risk factors requires narrowing down the domain, yet it is generally considered that the Ability and Willingness to Pay captures at a high level the main underlying driver of credit risk

Mitigation

Methodologies and procedures aiming to contain, manage or minimize credit risk are usually denoted Credit Risk Management, Credit Portfolio Management

Issues and Challenges

  • Credit risk is highly context dependent (dynamic nature) and in general not amenable to rigid frameworks
  • 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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