Credit risk quantification involves assigning measurable values to the likelihood of a borrower defaulting on a loan or other debt. Various factors, from borrower-specific attributes to broader market conditions, influence credit risk assessment. The fundamental premise is to objectively assess and predict liabilities, aiding lenders in safeguarding themselves against financial losses.
What Is Credit Risk?
Credit risk signifies the potential for a lender to incur financial losses when extending credit to a borrower. Borrowers can be categorized as low, high, or moderate risk.
The Federal Reserve highlights that credit risk is predominantly associated with loans for most banks. However, other credit risk sources, both on and off the balance sheet, exist. Off-balance sheet items encompass letters of credit, unfunded commitments, and lines of credit, while on-balance sheet risks include various financial products and services.
Lenders manage these risks through credit risk management strategies.
How Credit Risk Is Measured
Evaluation of credit risk involves assessing several key variables, such as the borrower’s financial health, the potential impact of default, credit extension size, historical default patterns, and macroeconomic indicators like economic trends and interest rates.
The three primary metrics for quantifying credit risk include probability of default, loss given default, and exposure at default.
Probability of Default
Probability of default (POD) indicates the likelihood of a borrower failing to meet scheduled debt payments. It typically incorporates factors like debt-to-income ratio and credit score for individual borrowers.
Businesses and entities issuing debt instruments have their default probability estimated by credit rating agencies. Higher default probabilities are associated with increased interest rates and required down payments, while collateral can mitigate default risks.
Loss Given Default
Loss given default (LGD) assesses the potential loss magnitude in the event of borrower default. While straightforward in concept, its calculation lacks uniformity. Factors influencing LGD include collateral, legal recourse, and overall portfolio risk assessment.
Lenders typically evaluate LGD across their loan portfolios rather than individual loans.
Exposure at Default
Exposure at default (EAD) gauges a lender’s total potential loss exposure at any given moment. This concept is pivotal not only for financial institutions but for all entities offering credit, accounting for outstanding balances and potential future credit utilization.
For credit products with limits, like credit cards, EAD computations should encompass both current balances and probable future increases pre-default.
The Bottom Line
Lenders utilize various tools, including probability of default, loss given default, and exposure at default, to evaluate and manage credit risks. Higher risk profiles often correspond to elevated borrowing costs or restricted access to credit.