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Recovery Risk

Average recovery rates in percentage of the outstanding debt value (book value or market value if listed in the markets) are positive. Regulators impose using, in the so-called Foundation Approach of Basel 24, recovery rates of 25% for subordinated debt and 55% for senior debts. The seniority level of debts sets which debt should be paid first, senior debts being paid back before subordinated debts are. Subordinated debt repayment is subject to prior repayment of other debts. Senior debts have a priority claim.

Economically, the amount of recoveries is not known in advance. It depends on guarantees and economic conditions of borrowers. Recovery risk refers to such uncertainty that arises at the time of default. Here, recovery risk designates the randomness of the proceeds from working out of a borrower's default.

Correlation and Concentration Risks

For portfolio of loans or fixed income instruments, another major driver of credit losses is loss correlation, which designates whether losses tend to occur independently from each other or whether they tend to appear jointly. The higher the loss correlation, the higher is the credit risk.

Loss correlation is similar to concentration risk. Concentration designates the fact that large amounts lent to a small number of borrowers of good credit standing results in very large losses, although with a low probability. A correlation is a different concept, since it applies to all borrowers whatever the size of their debt obligations. But it results in the same effect. If many small borrowers tend to default jointly, this results in a large loss, just as when a very large loan defaults.

Credit Risk in the Trading Portfolio

Capital markets value issuers' or obligors' credit standing according to credit risk. Unlike loans, the credit risk of traded debts is visible through public agencies' ratings, assessing the credit quality of public debt issues, or through changes of the value of their stocks. Credit risk is also explicit in credit spreads, the add-on to the risk-free rate defining the required market yield on credit risky debts.

The capability of trading market assets mitigates the credit risk since there is no need to hold these securities until the deterioration of credit risk materializes into effective default. Traders can liquidate positions as soon as they have bad news on an obligor. If the credit standing of the obligor declines, it is still possible to sell these instruments in the market at a lower value. The faculty of trading the assets limits the loss if sale occurs before default. The loss due to credit risk depends upon the value of these instruments and their liquidity. If the default is totally unexpected, traded instruments decline rapidly. The loss is the difference between the pre- and post-default prices. Unexpected defaults are not the exception, one example being Parmalat, an Italian firm whose default surprised all traders and bankers.

Spread Risk

Spread risk is another dimension of credit risk as viewed by the market, and applies to capital market instruments, typically to bonds. Credit spreads designate the spread between the risky yield of a bond and the risk-free rate. Credit spreads might depend on many factors. But they relate also to the uncertainty of contractual payments of debt issues. Credit spreads compensate investors for credit risk. Spreads narrow or widen both due to general economic or industry factors and due to events specific to an issuer. Such risks, general and specific, are sometimes called spread risk, and are evidently important for all books of fixed income instruments (bonds and fixed income derivatives).

Country Risk

Country risk, or sovereign risk, is, loosely speaking, the risk of a "crisis" in a country. Sovereign risk is the risk of default of sovereign issuers, such as central banks or government sponsored banks. Sovereign defaults actually materialize as debt restructuring, with the uncertainty being the duration of frozen debt payments.

In many cases, country risk designates "transfer risk." Transfer risk refers to the impossibility to transfer funds from the country, either because there are legal restrictions imposed locally or because the currency is not convertible any more. A common practice stipulates that country risk is a floor for the risk of a local borrower, or, equivalently, that the country rating caps the ratings of local borrowers. The rationale is that, if transfers become impossible, the risk materializes for all corporations in the country, and the transfer risk applies to the borrower whatever its credit standing.

 
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