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Credit risk is the most important risk in banking. It is the risk of a counterparty defaulting on payment obligations. Following regulations and the literature on credit risk, credit risk splits up in several "credit risk components":

• default risk

• migration risk

• exposure risk, which designates the uncertainty with respect to the future value of the amount subject to loss at the unknown time of default

• "loss given default" (LGD), or "loss under default," is usually less than the amount due because of recoveries arising from third party guarantees or collateral (assets pledged to the lender)

• counterparty risk is a specific form of credit risk that is encountered with derivative products, which can shift from one counterparty to the other.

Figure 3.1 summarizes the credit risk components. The figure shows "spread risk" in addition to the above. Spread risk designates the changes of spread between the risky return of risky assets and the risk-free rate (of government bonds). As it is explained in the valuation chap-

Credit risk components

FIGURE 3.1 Credit risk components

ter (Chapter 13), variation of spreads triggers changes of values, positive or negative, hence potential losses.

Next, we expand credit risk components.

Default Risk

Default risk is the risk that borrowers default, meaning that they fail to comply with their obligations to service debt. Default triggers a total or partial loss of any amount lent to the counterparty.

There are various default events such as: delay in payments obligations; restructuring of debt obligations due to a major deterioration of the credit standing of the borrower; bankruptcies. Simple delinquencies, or payment delays, do not turn out as plain defaults, with a durable inability of lenders to face debt obligations. Many are resolved within a short period (say less than 3 months). Restructuring is very close to default when it results from the inability of the borrower to face payment obligations unless its debt structure changes. Plain defaults imply that the non-payment will be permanent. Bankruptcies, liquidation of the firm or acquisition of a distressed firm, are possible outcomes. They trigger significant losses.

Conceptually, defaults are considered as an "absorbing state," that is an event such that the probability of migrating out of the default state is zero. This is not realistic since individuals might default on a consumer loan, for example, but might be able to face their financial obligations at a later date. In the US and other countries, bankruptcy law is designed to maximize the chance of survival of a firm that defaults, and require defining a business plan, possibly with other corporations, that has some chances of success. Therefore the default state might be a transient state.

Default depends on rules and conventions. The prevailing regulatory rule is that non-payment extends over at least 90 days. This is not a universal definition. For example, rating agencies, those organizations that provide rating to investors, consider that default occurs from the very first day of defaulting on the payment obligation of an issue.

"Issuer" risk designates the obligors' credit risk, which is distinct from the risk of a particular issue, among several of the same issuer, depending on the nature of the instrument and its credit mitigants (seniority level and guarantees).

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