Credit Risk Explained

person using a laptop and holding a bank cardCredit risk is the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection. Excess cash flows may be written to provide additional cover for credit risk. When a lender faces heightened credit risk, it can be mitigated via a higher coupon rate, which provides for greater cash flows.

Although it’s impossible to know exactly who will default on obligations, properly assessing and managing credit risk can lessen the severity of a loss. Interest payments from the borrower or issuer of a debt obligation are a lender’s or investor’s reward for assuming credit risk.

What is a Credit Risk Report?

As a part of his duties, a credit risk officer is also required to prepare periodic credit risk reports by collecting the key credit information and summarizing it in a meaningful manner. Such a report is useful and required for various purposes such as reporting to the top management, the board, and also for helping the credit risk officer decide the future course of action for managing risk.
Since there is a whole lot of information, the credit risk manager needs to decide and filter the relevant information that should be a part of the report. Of course, what information is included and what is not, will vary across financial institutions, we have listed below a few important pieces of information that should be a part of a credit risk report. Let’s look at these briefly.

1. Large Individual Exposures

One important set of information is the list of largest individual credit exposures. These credit exposures are large enough to have a significant impact on the bank even overnight due to an unexpected market movement, a new, or an event. The credit risk officer needs to list these exposures along with key information such as the amount of exposure, possible future events, change in credit exposure, and stress net, that is, the exposure under a stress condition. These large exposures can be categorized such as by credit rating, country, business type, etc.

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2. Portfolio Exposures

A good credit report will also contain the credit risk exposures at a portfolio level. Such information can be categorized by product type (banking book, trading book), etc., and should be complemented by information such as total exposure, ratings, geography, industry/sector, etc.

3. Credit Risk Concentrations

Since this is a major concern for banks, the credit risk officer needs to identify and report any risk concentrations, and the possibility of further diversification.

4. Changes in Credit Risk Variables

The credit risk report will also contain important changes in credit risk variables.

5. Watch List

The credit officers will usually be closely watching certain transactions or counterparty due to the nature of risk involved. Such items will also included in the credit risk report.

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