This lesson examines the techniques for measuring and managing credit risk, a primary risk for most banks .

3.1 Sources and Types of Credit Risk
Credit risk is the risk of financial loss from a borrower or counterparty failing to meet its obligations . Key sources include:

  • Individual Loans: Risk from consumer, corporate, and mortgage lending .

  • Counterparty Risk: The risk that a counterparty in a financial transaction (e.g., derivatives counterparty) defaults .

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

3.2 Credit Risk Measurement
Quantifying credit risk is essential for pricing and capital allocation. The University of Southampton module and NYU Stern course detail several key models :

  • Probability of Default (PD): The likelihood that a borrower will default over a given time horizon.

  • Loss Given Default (LGD): The percentage of the exposure that will be lost in the event of default.

  • Exposure at Default (EAD): The total value of the exposure outstanding at default.

  • Credit Risk Models: Advanced models such as the KMV model and CreditMetrics are used to estimate credit risk in a portfolio context .

3.3 Credit Risk Management
Techniques for managing credit risk include:

  • Diversification: Reducing concentration risk .

  • Collateral and Guarantees: Securing loans with assets or third-party guarantees .

  • Credit Derivatives: Instruments like credit default swaps (CDS) used to transfer credit risk .

  • Underwriting Standards: Implementing rigorous credit assessment and approval processes .

PreviousNext