Credit Risk is defined as “the potential financial loss arising from the failure of an obligor or issuer to meet its contractual obligation”.
Credit Risk exists therefore in two general forms: counterparty risk and issuer risk. Counterparty Risk occurs when a counterparty fails to fulfil its contractual obligations. A counterparty is one of the parties in a transaction (the buyer or the seller). Examples of Counterparty Credit Risk from a bank’s perspective include:
the risk that a client would default on it’s credit obligations (e.g. a loan)
the risk that a company with whom a bank does business goes bankrupt before and therefore defaulting on it’s credit obligations with the bank
the risk that a broker from whom the bank has purchased a security (e.g. bonds, shares) fails to deliver
In the case of Bonds, an additional sub-category of Credit Risk needs to be considered as the bond itself carries issuer risk. Issuer Risk occurs when the Bond issuer should default on its obligations to pay coupons or repay the principal on the bond.
Concentration Risk might also occur if a bank or company is too much dependent in a single counterparty. If that counterparty should default, that would adversely impact the bank’s business revenues. Nowadays banks have Risk Management frameworks and teams which manage risk exposures at counterparty, sectors, industry, country levels,m among others, aiming to diversify risk and avoid the materialisation of counterparty or concentration risks.
Our recent articles about Counterparty Risk