Credit risk is also known as default risk, and it is the risk-type to which the average bank is principally exposed, as a result of the make-up of its asset portfolio. As seen earlier, banks' loans (NMD and MD) typically comprise the largest proportion of their assets.
Credit risk is the risk that the borrower from a bank will default on the loan and/or the interest payable, i.e. that it will not perform in terms of the conditions under which the loan was granted. This is damaging to the bank, not only because of the actual loss eventually incurred, but also in terms of the time that management and bank counsel expend on attempting to recover the loss or a portion of the loss.
Asymmetric information, adverse selection and moral hazard
Lenders have asymmetric information, and this leads to the problem of adverse selection, which rears its ugly head before the loan is granted, and to moral hazard, which occurs after the loan is granted.
Asymmetric information means that the lender does not have information that is symmetric with that of the borrower, i.e. there is (or could be) a discrepancy between the information provided by the borrowing company (or person) and the actual state of affairs (financial and otherwise) of the company (or person). This means that the lenders are at a major disadvantage in terms of information about the borrower and, coupled with the fact that bad credit risks are more inclined to borrow than are good credit risks, the lenders are more likely to select borrowers with dubious projects (i.e. projects that have an adverse outcome) than borrowers with projects that will succeed.
Moral hazard means that after a loan is granted, there is a high probability that the borrower may engage in activities that do reflect the information gathered by the lender in connection with the borrower and his/her planned projects. There are countless examples where borrowers borrow with good intentions, but when the access to funds becomes a reality, they take on higher risk projects.
As banks are in the business of making loans, they are aware of the hazards, and have (in most cases) become authorities on solving the problems of asymmetrical information and its acolytes, adverse selection and moral hazard. Banks seek to mitigate the high probability of these through the introduction of appropriate credit risk management tools
Management of credit risk
Methods used by banks to mitigate credit risk include:
• Compensating balances and monitoring of business transactions
• Long-term customer relationships.
• Loan commitments.
• Collateral requirement.
• Credit rationing.
• Specialization in lending.
• Credit derivatives.
The obvious approach to alleviating credit risk is to avoid it. This can be achieved by only providing loans to, or buying the bonds of, government, the best credit. Because government securities are credit risk-free, the return enjoyed on such investments is of course the lowest available. Because the return on government securities is the risk-free rate (rfr), all other investments should yield rfr + rp (rp = risk premium). Note that while government bonds may be credit risk-free, they do carry market risk. It is also notable that there are some banks that are permitted to only invest in government securities (discussed later).
Diversification is the first principle of risk management as applied in portfolio theory. Banks typically do not lend a major proportion of their funds to individual borrowers. Rather, they restrict the amount loaned to a percentage of their capital. They are also diversified across economic sectors and countries. In most countries the bank regulator / supervisor stipulates a strict constraint in terms of loan concentration.
Banks also encourage diversification of borrowing by the borrower. The syndicated loan is an example.