Introduction to Credit Risk

Credit risk is the risk of an economic loss from the failure of a counter party to fulfill its contractual obligations. Its effect is measured by the cost of replacing cash flows if the other party defaults.

This chapter provides an introduction to the measurement of credit risk. Credit risk has undergone tremendous developments in the last few years. Fuelled by advances in the measurement of market risk, institutions are now, for the first time, attempting to quantify credit risk on a portfolio basis.

Credit risk, however, offers unique challenges. It requires constructing the distribution of default probabilities, of loss given default, and of credit exposures, all of which contribute to credit losses and should be measured in a portfolio context. In comparison, the measurement of market risk using value at risk (VAR) is a simple affair.

For most institutions, however, market risk pales in significance compared with credit risk. Indeed, the amount of risk-based capital for the banking system reserved for credit risk is vastly greater than that for market risk. The history of financial institutions has also shown that the biggest banking failures were due to credit risk.

Credit risk involves the possibility of non-payment, either on a future obligation or during a transaction. Section 18.1 introduces, which arises from the exchange of principals in different currencies during a short window. We discuss exposure to settlement risk and methods to deal with it.

Traditionally, however, credit risk is viewed as presettlement risk. Section 18.2 analyzes the components of a credit risk system and the evolution of credit risk measurement systems.

Section 18.3 then shows how to construct the distribution of credit losses for a portfolio given default probabilities for the various credits in the portfolio. The key drivers of portfolio credit risk are the correlations between defaults. Section 18.4 takes a fixed $100 million portfolio with an increasing number of obligors and shows how the distribution of losses is dramatically affected by correlations.

1 Settlement Risk

1.1 Presettlement vs. Settlement Risk

Counterparty credit risk consists of both presettlement and settlement risk. is the risk of loss due to the counterparty’s failure to perform on an obligation during the life of the transaction. This includes default on a loan or bond or failure to make the required payment on a derivative transaction. Presettlement risk can exist over long periods, often years, starting from the time it is contracted until settlement.

In contrast, is due to the exchange of cash flows and is of a much shorter-term nature. This risk arises as soon as an institution makes the required payment until the offsetting payment is received. This risk is greatest when payments occur in different time zones, especially for foreign exchange transactions where nationals are exchanged in different currencies. Failure to perform on settlement can be caused by counterparty default, liquidity constraints, or operational problems.

Most of the time, settlement failure due to operational problems leads to minor economic losses, such as additional interest payments. In some cases, however, the loss can be quite large, extending to the full amount of the transferred payment. An example of major settlement risk is the 1974 failure of Herstatt Bank. The day it went bankrupt, it had received payments from a number of counterparties but defaulted before payments were made on the other legs of the transactions.