Learning Objectives:

  • Define credit risk and identify its sources.

  • Apply credit risk assessment techniques.

  • Understand credit risk mitigation strategies.

2.1 Defining Credit Risk

Credit risk is the risk of loss from a borrower or counterparty failing to meet its obligations. As the University of Nottingham module states, commercial banks’ risk exposures include “interest rate risk, credit risk, liquidity risk, sovereign risk, market risk, operational risk, and insolvency risk” . Credit risk is the most significant risk for most banks and is a primary focus of lending operations .

Sources of Credit Risk:

  • Individual Borrowers: Risk of default by a specific borrower.

  • Portfolio Concentration: Over-exposure to a single borrower, sector, or geographic region.

  • Counterparty Risk: Risk of default by a counterparty in financial transactions (e.g., derivatives).

2.2 Credit Risk Assessment

The assessment of credit risk is a core function of commercial banking. The University of Adelaide course identifies “methods to measure and manage credit, market, operational, and liquidity risks” as a key learning outcome . Key techniques include:

  • The 5 Cs of Credit: Character, Capacity, Capital, Collateral, and Conditions.

  • Financial Statement Analysis: Analysing balance sheets, income statements, and cash flows.

  • Credit Scoring: Using statistical models to assess creditworthiness.

  • Internal Risk Ratings: Assigning risk grades to individual borrowers.

The BTRM programme explicitly covers “key principles of loan origination and credit risk management” .

2.3 Credit Risk Mitigation

Banks use several strategies to mitigate credit risk:

  • Diversification: Spreading exposure across borrowers and sectors.

  • Collateral: Securing loans with assets that can be liquidated in default.

  • Guarantees: Obtaining third-party guarantees to support repayment.

  • Loan Covenants: Imposing conditions on borrowers to manage risk.

  • Credit Derivatives: Using instruments like Credit Default Swaps (CDS) to transfer risk.

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