Enterprise Risk Management: From Incentives to Controls, 2nd Edition

CHAPTER 12

Credit Risk Management

The effective management of credit risk is a challenge faced by all companies, and a critical success factor for financial institutions and energy firms faced with significant credit exposures. Most obviously, banking institutions face the risk that institutional and individual borrowers may default on loans. Banks must therefore underwrite and price each loan according to its credit risk and ensure that the overall portfolio of loans is well diversified.

However, both financial and non-financial institutions also face credit risk exposures besides the default risk associated with lending activities. For example, the sellers of goods and services face credit risk embedded in their accounts receivable. Investors may see significant decreases in the value of debt instruments held in their portfolios as a result of default or credit deterioration. Sellers and buyers of capital markets products will only get paid on any profitable transaction if their counterparties fulfill their obligations to them. Furthermore, the increasing mutual dependence involved under arrangements such as outsourcing and strategic alliances exposes companies to the credit condition of their business partners.

Given this multiplicity of phenomena, there is obviously a need for a clear definition of credit risk. Credit risk can be defined as the economic loss suffered due to the default of a borrower or counterparty. Default does not necessarily mean the legal bankruptcy of ...