The quantification of credit risk is the process of assigning measurable and comparable numbers to the likelihood of default risk and the concept is a major frontier in modern finance. The factors that affect credit risk range from borrower-specific criteria to market-wide considerations. The idea is that liabilities can be objectively valued and predicted to help protect the lender against financial loss.
Several major variables are considered when evaluating credit risk: the financial health of the borrower; the severity of the consequences of a default (for the borrower and the lender); the size of the credit extension; historical trends in default rates; and a variety of macroeconomic considerations, such as economic growth and interest rates.
- Different factors are used to quantify credit risk, and three are considered to have the strongest relationship: probability of default, loss given default, and exposure at default.
- Probability of default measures the likelihood that a borrower will be unable to make payments in a timely manner.
- Loss given default looks at the size of the loans, any collateral used for the loan, and the legal ability to pursue the defaulted funds if the borrower goes bankrupt.
- Exposure at default looks at the total risk of default a lender faces at any given time.
Among all possible factors, three are consistently identified as having a stronger correlative relationship to credit risk: probability of default, loss given default, and exposure at default.
Probability of Default
The probability of default, sometimes abbreviated as POD or PD, expresses the likelihood the borrower will not maintain the financial capability to make scheduled debt payments. For individual borrowers, default probability is most represented as a combination of two factors: debt-to-income ratio and credit score.
Credit rating agencies estimate the probability of default for businesses and entities that issue debt instruments, such as corporate bonds. Generally speaking, higher PODs correspond with higher interest rates and higher required down payments on a loan. Borrowers can help share default risk by pledging collateral against a loan.
Loss Given Default
Imagine two borrowers with identical credit scores and identical debt-to-income ratios. The first borrower takes a $5,000 loan, and the second borrows $500,000. Even if the second individual has 100 times the income of the first, their loan represents a greater risk. This is because the lender stands to lose a lot more money in the event of default on a $500,000 loan. This principle underlies the loss given default, or LGD, factor in quantifying risk.
Loss given default seems like a straightforward concept, but there is actually no universally accepted method of calculating LGD. Most lenders do not calculate LGD for each separate loan; instead, they review an entire portfolio of loans and estimate total exposure to loss. Several factors can influence LGD, including any collateral on the loan and the legal ability to pursue the defaulted funds through bankruptcy proceedings.
Exposure at Default
Similar in concept to LGD, exposure at default, or EAD, is an assessment of the total loss exposure a lender is exposed to at any point in time. Even though EAD is almost always used in reference to a financial institution, the total exposure is an important concept for any individual or entity with extended credit.
EAD is based on the idea that risk exposure depends on outstanding balances that can accrue before default. For example, for loans with credit limits, such as credit cards or lines of credit, risk exposure estimates should include, not just current balances, but also the potential increase in the account balances that might happen before the borrower defaults.