Introduction to Credit Risk*
Credit risk is the risk of an economic loss from the failure of a counterparty to fulfill its contractual obligations. Its effect is measured by the cost of replacing cash flows if the other party defaults.
This chapter provides an introduction to the measurement of credit risk. The study of credit risk has undergone vast developments in the past few years. Fueled by advances in the measurement of market risk, institutions are now, for the first time, attempting to quantify credit risk on a portfolio basis.
Credit risk, however, offers unique challenges. It requires constructing the distribution of default probabilities, of loss given default (LGD), and of credit exposures, all of which contribute to credit losses and should be measured in a portfolio context. In comparison, the measurement of market risk using value at risk (VAR) is a simple affair. These challenges explain why many of these models performed poorly during the credit crisis that started in 2007.
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.
Credit risk involves the possibility of nonpayment, either on a future obligation or during a transaction. Section 19.1 introduces settlement risk ...