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What is credit risk

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    Benton Li
    Twitter

Before we define credit risk, let’s ask this question: what is credit?

What’s the relationship between credit and debit?

Debits record incoming money, whereas credits record outgoing money

Source: First Republic

Definitions

Credit risk: A risk that your lent money is not going back lmao.

This is not a formal definition. We’ll revisit the definition at the end of the post.

Where does credit risk come from?

For banks:

  • Overdraft
  • Loans
  • Mortgage
  • Credit card
  • Sometimes we count foreign exchange and derivatives as a source too
  • …

For traders: sellers take risks when buyers buy now pay letter (e.g. 30-60 days later)

Other sources: e.g. You pre-order Apple’s newest iPhone. (risk is small but still exists)

How do you measure/quantify it?

There are several metrics that need to be taken into consideration. We mainly look at these 3:

  • Exposure at Default (EAD): How much you are gonna lose when your counterparty doesn’t pay you
  • Probability of Default (PD): Chance that your counterparty doesn’t pay you.
  • Loss Given Default (LGD): When default happens, you don’t just do the L dance. You will try to minimize your loss. For instance, sue them. For another instance, sell the collaterals. LGD is just the amount of loss net of recoverable amounts.

(Wtf does default mean?)

What am I gonna do with credit risk?

Suppose you go to a steak restaurant with your girlfriend. You are giving trust to the chef (who is ironically your customer) and there is a chance that you get a burnt steak.

Here’s a typical credit risk management cycle:

  1. Assessment:
    1. Type of customer(chef): Who’s cooking? Gordon?
    2. Type of facility: what kind of meal am I getting?
    3. Risk metrics such as:
      • EAD: How much of my steak is on the stove?
      • PD: What’s the likelihood of my steak being fucked
      • LGD: Ok given that the steak is burnt, how much of it is edible lmao
    4. Risk appetite: “Monsieur, how would you like your steak to be cooked?”
    5. Time frame: how long am I going to wait for my steak?
  2. Decision
    1. Approve: basically a yes
    2. Approve with terms and conditions: Yes with conditions like the refundable option
    3. Decline with or without the option of appeal: No. I can leave. I can also ask if I can modify my dish.
  3. Documentation (if any)
  4. Reporting:
    • At the customer level: show limits and utilization levels for all facilities (Hey chef, if you want you can cook extra, I will pay)
    • At the portfolio level: show concentration risk, delinquency levels, and trends (Hey Kakei or dear stomach, there is a chance we eat charcoal)
  5. Monitoring events like:
    1. Late payments (wait too long for the steak)
    2. High utilization of overdraft facilities (I smell a lot of smoke from the kitchen)

Read more :

Counter-party credit risk (CCR)