What is credit risk?

I received my latest copy of IDEA’s Economic Digest and it discussed a very timely topic on Credit Risk. Economic Digest is a regular digest produced by the Institute for Development and Econometric Analysis, Inc. (IDEA) whose Chairman, Dr. Cayetano W. Paderanga Jr., is a former mentor. I am sharing this with you, as I know that a lot of my readers are in the Credit & Collection (C&C) practice. 

According to IDEA, “Credit Risk, is broadly defined as the uncertainty arising from an obligor’s capability to meet its obligations. It is also used interchangeably with default risk, since it represents the possibility of counterparty defaulting on the principal or interest payments (or both) on its debt obligations. The measurement of an entity’s credit risk covers the credit quality of the obligation, as well as its credit exposure, after which a credit score or credit rating is assigned as a guide for investors and lenders, such as in the determination of the appropriate interest rates.”

Furthermore, it was reported that Credit risk and its assessment take various forms since counterparties can range from individuals, small businesses, large institutions and countries, while the types of debt obligations have broadened to include more sophisticated financial instruments such as derivatives and exotic securities. In measuring credit risk, the nature of the debt instrument is equally important since it has its own degree of risk. For instance, secured debt has generally higher credit quality than do the subordinated debt of the same issuer. Bonds issued by the government is considered immune from default; default in municipal bonds occurs but are less common, while corporate bonds are in the other end of the default spectrum. Nevertheless, credit risk is usually measured through an examination of 1) default probability, or the likelihood that the obligor will default any time during the life of the obligation; 2) credit exposure, or the remaining outstanding amount when default occurs; and 3) recovery rate, or the fraction of the credit exposure that will most likely be paid after the default happens. When an investor assumes credit risk, such as in the purchase of a corporation’s debt security, the compensation for the risk is measured by the credit spread. It is simply the difference between a relatively safe security, such as a government treasury, and the corporate bond, according to the same publication.

The measurement of credit risk may thus be formulaic, or requiring a long or complicated process involving both qualitative and quantitative elements. For financial institutions that lend to individuals or small businesses, credit scoring is usually deemed sufficient. In these cases, lending institutions usually apply a standard formula to client information gathered a priori. These formulas result in credit scores that guide the lender’s decision. Another method of credit risk assessment is credit analysis, usually applied to large institutional counterparties or countries as well as to debt securities. It differs from credit scoring in that it incorporates a greater degree of human judgment to analyze counterparty information that cannot be easily captured by any formula. These information include the characteristics of its industry or operating environment, macroeconomic conditions, regulatory and administrative constraints, among others. A notable difference between credit scoring and credit rating is that some lending institutions have their internal credit scoring systems, but credit ratings (acknowledged by local/foreign investors) are usually undertaken by third-party credit rating agencies.

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