This lesson establishes the foundational principles of credit risk, its sources, and the governance frameworks that ensure prudent risk-taking.

5.1 Defining Credit Risk
Credit risk is the risk of financial losses in the event of a default, where defaults arise from an inability to meet timely financial obligations . It is the most significant risk faced by most financial institutions and a key focus of regulatory oversight . Credit risk management is a comprehensive discipline encompassing the origination, assessment, mitigation, and recovery of credit exposures .

5.2 Sources of Credit Risk
Credit risk can arise from various sources:

• Default Risk: The risk that a borrower fails to meet its repayment obligations.

• Credit Migration Risk: The risk that a borrower’s credit rating deteriorates, increasing the probability of default.

• Counterparty Risk: The risk that a counterparty in a financial transaction defaults.

• Concentration Risk: The risk of losses from over-exposure to a single borrower, sector, or geographic region .

5.3 The Governance of Credit Risk
Effective credit risk management requires a robust governance framework . Key elements include:

• Board and Senior Management Oversight: Setting the risk appetite and ensuring that credit risk is managed within defined limits.

• Credit Policy: A formal document outlining lending criteria, risk limits, and approval authorities .

• Segregation of Duties: Separation of origination, underwriting, approval, and monitoring functions to prevent conflicts of interest .

• Risk Appetite Statement: Defining the types and amounts of credit risk the institution is willing to accept .

5.4 Regulatory Frameworks
Credit risk management is governed by a range of regulatory requirements, including:

• Basel Standards: The Basel Accords provide a global framework for capital adequacy and risk management .

• Regulatory Reporting: Financial institutions must report on credit risk exposures, asset quality, and capital adequacy .