For most institutions, however, market risk pales in significance compared

with credit risk. Indeed, the amount of risk-based capital for the banking system

reserved for credit risk is vastly greater than that for market risk. The history of

financial institutions has also shown that the biggest banking failures were due to

credit risk.

Creditriskinvolvesthepossibilityofnonpayment,eitheronafutureobligation

or during a transaction. Section 19.1 introduces settlement risk, which arises

from the exchange of principals in different currencies during a short window,

typically a day. We discuss exposure to settlement risk and methods to deal

with it.

Traditionally, however, credit risk is viewed as presettlement risk, which arises

during the life of the obligation. Section 19.2 analyzes the components of a credit

risk system and the evolution of credit risk measurement systems. Section 19.3

then shows how to construct the distribution of credit losses for a portfolio given

default probabilities for the various credits in the portfolio