Banks and Bank Risks – Credit Risk

Categories of Banking Risk

In banking and finance, the term 'risk' is generally associated with financial losses, but it
is more accurately described as uncertainty about the returns that will be earned on an
asset. It is an inherent part of a bank's business to bear certain risks in order to generate
returns for its shareholders.

Banks are exposed to a significant number of risks, which can be categorised into:

• credit risk
• operational risk
• liquidity risk
• market risk

How a bank defines these risks is important, as the definitions are the basis for both the
qualitative and quantitative assessment of the bank’s exposure to the risks. As a result,
the generally accepted definitions have been continually refined over the years, helped
in no small part by supervisory authorities imposing capital charges and related
requirements against these risks.

In this tutorial, we will focus on credit risk.

Do You Know? - Asymmetry of Risks

Banks’ risk exposures are asymmetric. For example, in relation to credit risk, the upside
of an exposure is generally a small positive yield, whereas the downside can be a loss of
up to 100% of the exposure.

This perceived asymmetry in risks means that banks tend to focus on identifying and
managing the key risk drivers that are more likely to result in losses. For example, when
conducting stress tests of their portfolios, they focus on the negative aspects of an
exposure. In the case of:

• credit risk, stress tests focus more on economic recessions than recoveries
• equity prices, stress tests focus more on stock market crashes than booms
• interest rates, stress tests focus more on increases than decreases

© Bank for International Settlements. All rights reserved. Page 1 of 9

Credit Risk
Credit risk is the potential that a bank's borrower or counterparty will fail to meet its
obligations in accordance with agreed terms. It is the single largest factor threatening the
soundness of banks, most other financial institutions and the financial system as a
whole.

The chart below illustrates the significance of credit risk relative to market and
operational risks in over 200 of the largest internationally active banks as of the end of
June 2016. Each segment in the pie charts reflects the proportion of minimum required
capital accounted for by each risk type. As you can see, credit risk accounts for over
80%, on average.

© Bank for International Settlements. All rights reserved. Page 2 of 9

Credit Risk Is Pervasive
Credit risk arises any time bank funds are extended, committed, invested or otherwise
exposed, whether reflected on or off the balance sheet. It can result from a variety of
factors, including:

• weak or non-existent credit underwriting standards for borrowers

• lax loan portfolio management
• poor or deteriorating economic conditions

Credit risk is found in all banking activities where the profitability of that activity (for
example, lending to individuals) depends on whether or not the counterparty or borrower
repays the debt. For most banks, loans are the largest and most obvious source of credit
risk.

© Bank for International Settlements. All rights reserved. Page 3 of 9

Counterparty Credit Risk
Counterparty credit risk is a particular type of credit risk. It stems from a bank’s
transactions with trading partners, rather than borrowers, and is defined by the Basel
Committee on Banking Supervision (BCBS) as the risk that the counterparty to a
transaction could default before the final settlement of the transaction’s cash flows. The
bank would suffer an economic loss if the market value of the transaction is positive (that
is, if the counterparty owes the bank) at the time of the default.

Unlike a bank’s exposure to credit risk through a loan, where the exposure is unilateral
and only the lending bank faces the risk of loss, counterparty credit risk creates a
bilateral risk of loss. The market value of the transaction can be positive or negative to
either the bank or its counterparty. It is uncertain and can vary over time with the
movement of underlying market factors.

Derivatives transactions, such as interest rate and currency swaps, credit default swaps
(CDS) and equity derivatives, are examples of transactions that give rise to counterparty
credit risk.

Do You Know? - The BCBS

The BCBS is the primary global standard setter for the prudential regulation of banks
and provides a forum for cooperation on banking supervisory matters. Its mandate is to
strengthen the regulation, supervision and practices of banks worldwide with the
purpose of enhancing financial stability. You can learn more about the BCBS’s mandate
and activities by exploring their website.

Flashback - Lehman Brothers and Counterparty Credit Risk

The fall of Lehman Brothers on 15 September 2008 ushered in a new era for
counterparty credit risk. On that day, thousands of creditors lost hundreds of billions of
dollars due to their exposure to Lehman in the form of counterparty credit risk. In
response, international standard setters like the BCBS, together with the industry, began
working to establish clearing houses and central counterparties (CCPs) for derivatives.
The overall objective of this initiative is to reduce the risk in these transactions and
enable market participants to trade with confidence that contracts will be settled in full.

© Bank for International Settlements. All rights reserved. Page 4 of 9

Credit Risk – Loans
Let’s take a closer look at the nature of credit risk arising from a bank’s lending activity
by walking through a simplified illustration.

Best Bank has a loan portfolio of USD 10,000, consisting of 10 loans with a principal
amount of USD 1,000 each and a maturity of one year.

The annual interest rate on each loan is 10%, with interest payable on maturity. Let's
calculate the total interest revenue on the loan portfolio.

If the annual interest rate on each loan is 10%, with interest payable on maturity,
what is the total interest revenue on the loan portfolio?

• USD 100
• USD 1,000 (correct answer)
• USD 1,100
• USD 10,000

The interest collected on each loan would be USD 100 (10% x USD 1,000), for total
interest revenue on the loan portfolio of USD 1,000.

This table illustrates how the total interest revenue on the loan portfolio amounts to USD
1,000.

© Bank for International Settlements. All rights reserved. Page 5 of 9

One of the borrowers is declared bankrupt and defaults on its loan six months
after it was advanced. What impact will this have on the bank's operating results?

• The effect will be minimal as the interest revenue will only be reduced by USD
100.

• The loss on this loan will exceed the bank’s interest revenue and considerably
reduce the portfolio’s revenue. (correct answer)

In addition to forgoing the interest revenue (USD 100), Best Bank must write off the
principal amount of the loan (USD 1,000). As a result, the loss on this one loan has
wiped out the expected interest revenue on the entire loan portfolio.

This table illustrates how the loss on one loan has wiped out the expected interest
revenue on the entire loan portfolio.

While this example has been simplified for the purposes of illustration, it does
demonstrate that default by even a small number of borrowers can generate significant
losses for a bank. At the extreme, it can lead to a bank’s insolvency.

© Bank for International Settlements. All rights reserved. Page 6 of 9

Credit Risk – Duration Matters
All else being equal, long-term lending exposes a bank to more risk than short-term
lending because of the length of time the loan is outstanding. In essence, the longer the
term of a loan the greater the uncertainty about the borrower’s ability to repay because
of the increased opportunity for adverse changes in the borrower’s financial condition.

Because of the greater risk involved, long-term loans are generally priced higher than
short-term loans. They are also more likely to be secured and will generally be subject to
regular amortisation, which requires the loan to be repaid over time in periodic
instalments of principal and interest. Amortisation results in a declining principal balance
such that the loan is fully repaid by the time it matures.

Secured
A loan is secured when the borrower gives the bank a security interest in an asset (for example, a car
or house that the loan was used to purchase) which the bank can then use in settlement of the loan if
the borrower defaults.

© Bank for International Settlements. All rights reserved. Page 7 of 9

Sources of Credit Risk
Apart from traditional loans, credit risk arises from:

• investments in corporate and government debt instruments

• credit card loans
• loans by way of overdraft
• letters of credit
• deposits with other financial institutions
• financial guarantees

Banks are also exposed to credit risk from a variety of non-lending products, activities
and services, such as:

• derivatives, repurchase agreements and other trading activities

• cash management services
• trade financing

Letters of Credit
A letter of credit is a credit instrument issued by a bank on behalf of its customer, often an importer,
guaranteeing payment to a third party, often an exporter, up to a specified amount, provided that the
specified terms and conditions are met.

Financial Guarantees
When a bank issues a financial guarantee on behalf of a client, it is guaranteeing to a third party (the
beneficiary) that the liabilities of its client to that third party will be met. If the client fails to settle its
debt to the third party, the bank will step in and cover it.

© Bank for International Settlements. All rights reserved. Page 8 of 9

Review Question
In which of the following situations is a bank exposed to credit risk?

• The bank purchases GBP 100 million gilts (UK government securities).
(correct answer)

• The bank buys GBP 5 million worth of shares in a beverage company that is
listed on the London Stock Exchange.

• The bank has a contingent liability of GBP 5 million due to a legal suit filed by a
customer.

Credit risk arises when the bank buys GBP 100 million in gilts, even though the potential
for the UK government defaulting on its debt obligations may be regarded as extremely
low. Purchasing shares in the beverage company exposes the bank to market risk, not
credit risk. In this case, the contingent liability (a liability that may occur, depending on
the outcome of an uncertain event) is an example of legal risk, which is a form of
operational risk.

© Bank for International Settlements. All rights reserved. Page 9 of 9