What is Credit Risk Exposure?

Businesses are inherently risky. It is the one thing that unites them across sectors and geographies. While organizations can't run without risks, they can mitigate them. Companies that survive in the long run are often the ones which take calculated risks. This article highlights one of the many risks a business faces - credit risk and the exposure thereon.

Credit risk exposure

To understand credit risk exposure, it is vital to first understand credit risk. It is the possibility of a borrower not repaying the amount owed, resulting in disruption of cash flows and increased cost of collection for the lender. A few examples of credit risk can be:

• A borrower not paying interest or principal or both due on a mortgage loan or credit card
• A debtor unable to clear his trade invoice
• A business failing to pay outstanding salaries or wages,
• Companies unable to make timely coupon or principal payments on debt raised by it, etc.

Credit risk exposure is a part of credit risk. It is the maximum loss a lender would suffer if a borrower defaults. Other components of credit risk include:

• The default probability: an estimation for calculating how likely it is that the borrower will default on his obligations

• Recovery rate: the portion of bad debts that can potentially be redeemed through recovery proceedings or debt collection efforts.

Types of credit risk

Credit risk can be of three types:

1. Credit default risk

   This is when a borrower does not meet his loan obligation and 90 days have passed since the due date. All credit-sensitive financial transactions like loans, bonds, derivatives, etc., are vulnerable to this form of risk.

2. Concentration risk

   When the lender's risk is associated with a single exposure or group of exposures that can likely damage the business's core operations. This arises typically when portfolios are not diversified enough or companies rely on one party for a significant portion of their sales.

3. Country risk

   The possibility of a country defaulting on its foreign currency payment obligations is referred to as country risk. Country risk is closely associated with a sovereign state's political stability and macroeconomic performance.

How is credit risk exposure calculated?

Although it's not possible to know when and who will default on obligations, organizations and individuals can make assessments and manage their credit risk exposure or expected loss.

Expected loss = Probability of default * Exposure at default * Loss given default

For example, ABC Bank grants a loan of INR 100,000 to its customer Mr X against the collateral of his house property. His business is suffering heavy losses, and he recently defaulted on making payments to his creditors. The default loss is 40%. ABC Bank can recover the remaining amount from the house property held as collateral. The Bank can calculate the loss expected due to credit default as under:

Probability of default (PD) = 100% (assuming Mr X will not be able to pay anything)

Exposure at default (EAD) = INR 100,000

Loss given deafult (LGD) = 40%

Expected loss = PD * EAD * LGD

Expected loss = 100% * 100,000 * 40%

Expected loss = INR 400,000

Companies can assess consumer credit risk using 5Cs: credit history, capacity to repay, capital, conditions of the loans, and collateral. Consumers with a high-risk profile may be required to pay a higher coupon rate and vice-versa.

Credit-rating agencies such as CRISIL, ICRA assess the credit-risk profiles of bond issuers and assign them a rating. Before investing in corporate bonds, individuals can review these credit ratings and invest according to their risk appetite. A low credit rating (less than BBB) means a high risk of default. On the contrary, a high credit rating denotes that the bond is significantly less risky.

Lenders also use financial statement analysis, machine learning, and default probability to assess risk. However, these can be inaccurate. Hence, lenders need to rely on their judgement and make the final call.

What is the use of credit risk exposure?

By analyzing their credit risk exposure, lenders can use suitable ways to limit their risk. For example, lenders may choose to increase their collateral requirements or disburse loans at a higher interest rate for a person with no or bad credit history. For a person with a good credit score, that same lender may give a loan with a higher principal amount and lower interest rate. Likewise, investors with a low-risk appetite may not prefer to invest in bonds with low ratings.

Lenders may also purchase credit default swaps to limit their credit risk exposure. In a credit default swap, the swap seller accepts the risk of the debt and, in turn, receives a premium from the swap buyer. The seller compensates the buyer with interest payments. If the borrower defaults, the seller returns the premium to the buyer.