Credit Risk

The risk of a counterparty not fulfilling their obligations on the due date is a risk that affects any
business enterprise. Credit risk is also the risk to which financial regulators pay closest attention
as it is the most significant risk faced by banks (and the risk against which they hold the most
regulatory capital).

This tutorial introduces the concept of credit risk, its sources in the banking and trading books of
financial institutions, the factors behind it, and how credit risk is rated.

Off-Balance Sheet Items in the Banking Book

An off-balance sheet item is a financial instrument that does not appear on the lender's
books but represents an actual contractual obligation. It may be converted at a later date
to an on-balance sheet item. The main off-balance sheet items are:

 Loan commitments
 Lines of credit

Loan Commitments:

Credit risk exposure is created when a bank makes a loan commitment. This is a written
agreement valid for a specific duration, signed by the borrower and lender, detailing
terms and conditions under which a loan of up to a specified amount will be made. For
agreeing to make this promise, the bank usually requires one or both of the following:

 Payment of a fee
 Maintenance of a compensating balance by the customer

Lines of Credit

Less detailed than a formal loan commitment is a line of credit. There are different lines of credit
which may or may not be disclosed to the customer, as the table shows:

Credit Risk vs Default Risk

Credit risk is often used synonymously with default risk. However, default risk is the risk that the
borrower will miss a repayment, while credit risk refers to the risk that the borrower will not be
able to repay the entire loan and the potential loss if this occurs.