How Credit Risk Exposure Impacts Your Investments

Credit risk is an inherent part of any lending activity. It refers to the possibility that a borrower may default on their debt obligations owed to the lender. This results in a loss to the lender through unpaid interest and principal amounts. Thus, assessing and managing credit risk exposure is critical for lenders to ensure sustainable operations. 

This article will guide the ins and outs of credit risk analysis to equip lenders with a framework to quantify and minimise their credit risk exposure.

Understanding credit risk exposure 

Credit risk exposure refers to a lender’s potential loss due to credit default. It enables lenders to gauge the maximum possible hit to their bottom line if the borrower fails to repay as agreed. The critical aspects in determining credit risk exposure are:

1. Probability of Default (PD): The PD reflects the probability of default based on the borrower’s credit profile. A higher PD means a riskier borrower.

2. Exposure at Default (EAD): The total value of credit exposure under the facility at the time of default. For a term loan, this is the principal outstanding amount. 

3. Loss Given Default (LGD): The part of EAD that may be lost post borrower’s default even after recovery efforts. It is expressed as a percentage of EAD.

Credit risk exposure is thus calculated as:

Credit Risk Exposure = PD x EAD x LGD

For instance, if a lender has extended a loan of ₹100,000 to a borrower with a PD of 10%, EAD of ₹100,000, and LGD of 60%, the credit risk exposure is: 

0.1 x ₹100,000 x 60% = ₹6,000

So the maximum loss the lender can incur if the borrower defaults is ₹6,000

Approaches to measure credit risk exposure

Lenders use different methods to evaluate the creditworthiness of borrowers and calculate the level of credit risk involved:

1. Quantitative Approach: Evaluates credit risk using financial statements, credit reports, credit scores, cash flows, financial ratios like debt-equity ratio, etc. This is an objective assessment.

2. Qualitative Approach: Analyses management capability, industry outlook, operating environment, company standing, etc., based on expert judgment. 

3. Combined Approach: Good credit decisions consider numbers and opinions for a complete risk profile.

Credit risk exposure is the chance that borrowers cannot repay their loans. Lenders can measure this risk by looking at income stability, economic conditions, and collateral value. To manage this risk, lenders should adopt a customised approach that fits their lending operations.

Practices for Lenders to Minimise Credit Risk Exposure

While some credit risk is inevitable, lenders can mitigate it by following a disciplined risk management approach:

1. Diversify Lending Portfolio: Avoid concentration by limiting exposure to any borrower/industry. This containment strategy cushions against personal or sector-specific shocks. 

2. Stress Testing: Evaluate the credit portfolio’s resilience under stressful conditions like rising inflation or financial crises. This aids in proactive risk mitigation.

3. Know Your Customer: Thoroughly assess the borrower’s profile, including identity, credit history, financial health, etc. This filters risky applicants.

4. Appropriate Loan Pricing: Balance risk-return trade-off by charging higher rates from high-risk borrowers. This compensates for the incremental risk.

5. Review Concentration Limits: Periodically examine max exposure thresholds across borrower categories to align with portfolio objectives. This ensures breaches can be addressed on time. 

6. Robust Collection Mechanism: Chase delinquent accounts aggressively to keep NPAs and write-offs in check. This shrinks potential “Loss Given Default”.  

7. Seek Security Cover: Collateral acts as a secondary payment source upon default. Thus, secure hard assets as a buffer against credit losses.

Hence, lenders must dynamically track “how to calculate credit risk exposure” and modify policies to steer their portfolios to stay profitable while supporting credit access.

Understanding counterparty credit risk exposure

Lenders face credit risk not just from borrowers but also from counterparties they deal with. For instance, financial contracts like forwards, swaps, repos, etc., entail counterparty credit risk. Here, default by either party would result in replacement costs for the other entity. 

Some critical considerations while assessing “counterparty credit risk exposure” are:

1. Nature of Interlinked Contracts: Analyse how obligations are interdependent, including embedded triggers and intermediaries involved.

2. Marked-to-Market Value Fluctuations: Estimate exposure based on regular changes in instruments’ fair value amid market movements.

3. Adequacy of Collateral Arrangement: Ensure credit support annexure sufficiently covers current and future exposure via margin calls.

4. Netting Agreements: Setoff arrangements compress exposure to the net payable/receivable amount upon default.

Conventional credit risk management requires understanding complex deal dynamics and prudent contracting.

Interlink of credit exposure and risk-weighted assets  

Basel norms stipulate capital requirements for banks based on the risk profile of their asset portfolio. “credit exposure and risk-weighted assets” demonstrate an exciting interplay here.

Banks calculate credit exposure under each facility they grant and multiply it by a risk weight (assigned per Basel guidelines) to derive risk-weighted assets. A higher risk weight denotes greater underlying credit risk.

For instance, cash carries zero risk weight, interbank loans 20%, housing loans 35%, commercial loans 100%, etc. So, for a housing loan of ₹100,000, the credit exposure and risk-weighted asset would be:

• Credit Exposure = Loan Amount = ₹100,000
• Risk Weight for Housing Loans = 35% 
• Risk-weighted assets = Credit Exposure x Risk Weight  

            = ₹100,000 x 35% = ₹35,000

Thus, housing loans lead to lower risk-weighted assets than commercial loans of the same ticket size. Banks must hold capital up to 8% of risk-weighted assets. Here, prudent credit appraisal helps optimise regulatory capital for banks by checking avoidable credit risks.

Special considerations for credit risk exposure of derivatives

Dealing with derivatives like forwards, futures, swaps, etc. entails manifold risks. Counterparty credit risk is pivotal among them since it involves deferred settlements.  

Some aspects crucial to gauging “credit risk exposure for derivatives” are:

1. Notional Value vs. Replacement Cost: Exposure is based on the instrument’s replacement cost upon default rather than the inflated notional value.

2. Volatile Mark-to-Market: This can dramatically swing the derivative portfolio’s value, necessitating robust credit lines to fund margin obligations. 

3. Close-out Netting: Dealers enter reciprocal transactions which get netted upon one party’s default. This curtails credit exposure to the positive MTM value. 

4. Collateral Exchange: Daily margining through cash/securities minimises credit exposure even before final settlement.

Therefore, derivatives dealers must dynamically evaluate changing MTM values, netting sets and collateral adequacy to control credit risk. 

Conclusion

Lenders are always taking a risk when they give out loans. But by making smart decisions and following good practices, they can balance the risk and reward and be profitable in the long run. The most important thing is identifying, measuring, and reducing the risk of not getting paid back by the people or companies that borrow money. In the future, it will be necessary for lenders to take risks carefully rather than avoiding them altogether.

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