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)
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 Natural 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.
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
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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