The quantification of credit risk is the process of assigning measurable and comparable numbers to the likelihood that a borrower won't repay a loan or other debt. The factors that affect credit risk range from borrower-specific criteria to market-wide considerations. The concept behind credit risk quantification is that liabilities can be objectively valued and predicted to help protect the lender against financial loss.
- Lenders look at a variety of factors in attempting to quantify credit risk.
- Three common measures are 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 loan, 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 that a lender faces at any given time.
What Is Credit Risk?
Credit risk refers the likelihood that a lender will lose money if it extends credit to a borrower. Any given borrower may be judged to be of low risk, high risk, or somewhere in between.
"For most banks," the Federal Reserve notes, "loans are the largest and most obvious source of credit risk. However, there are other sources of credit risk both on and off the balance sheet. Off-balance sheet items include letters of credit, unfunded loan commitments, and lines of credit. Other products, activities, and services that expose a bank to credit risk are credit derivatives, foreign exchange, and cash management services."
Lenders attempt to identify, measure, and mitigate these risks through credit risk management.
How Credit Risk Is Measured
Several major variables are considered when evaluating credit risk. Those include the financial health of the borrower, the severity of the consequences of a default (for both 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.
The three most widely used measures associated with credit risk are: probability of default, loss given default, and exposure at default. Here is how each of those works:
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 often 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 other 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 it. Most lenders do not calculate LGD for each separate loan; instead, they review an entire portfolio of loans and estimate the 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 that a lender faces at any point in time. Even though EAD is almost always used in reference to a financial institution, 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.
What Is a Good Credit Score for an Individual?
Credit scores are generally calculated on a scale from 300 to 850. A "good" score is often in the range of 670 to 739, while scores of 740 to 799 are considered "very good," and 800 and higher is "excellent," according to the credit bureau Equifax. Individual lenders may set these bars higher or lower in judging credit applicants.
What Is a Good Credit Rating for a Company?
Credit rating companies, such as Moody's, Standard & Poor's (S&P), and Fitch Ratings, assess companies' debt using letter grades. While their rating systems differ in various respects, "A" grades are better than a "B" grades, double- or triple-"A" grades are better than a simple "A," and so forth. The lowest grades, in the "C" or "D" levels, are considered to be of the greatest risk, often referred to as junk.
What Is Concentration Risk?
Concentration risk refers to another hazard that lenders may face. It considers how much of their lending portfolio is concentrated on a particular borrower (or small group of borrowers) or in a particular sector of the economy. The highly publicized failure of Silicon Valley Bank in March 2023 has been attributed at least in part to concentration risk, due to the bank's heavy investment in a single type of debt, namely long-term Treasury bonds.
The Bottom Line
Lenders can use a number of tools to help them assess the credit risks posed by individuals and companies. Chief among them are probability of default, loss given default, and exposure at default. The higher the risk, the more the borrower is likely to have to pay for a loan if they qualify for one at all.