What is Credit Exposure
Credit exposure is the total amount of credit made available to a borrower by a lender. The magnitude of credit exposure indicates the extent to which the lender is exposed to the risk of loss in the event of the borrower's default. Credit exposure can be minimized through purchasing credit default swaps or other types of financial instruments.
BREAKING DOWN Credit Exposure
Credit exposure is the maximum amount that will be lost if the counterparty to a contract defaults. For example, if a bank has made short-term and long-term loans totaling $100 million to company A, its credit exposure to company A is $100 million. In general, a bank seeks to have greater credit exposure to its customers with the highest credit rating and less exposure to clients with a lower credit rating. If a customer encounters unexpected financial problems, the bank may seek to reduce its credit exposure to mitigate the risk of loss arising from a potential default.
How Lenders Control Credit Exposure
Lenders have several methods for controlling credit exposure. Certain practices are simple, such as a credit card company setting credit limits based on its estimate of a borrower's ability to repay. Limiting a college student with no credit history to $300 until he establishes a seasoned track record of making on-time payments while offering a $100,000 limit to a high-income customer with a FICO score above 800 is an example of a credit card company reducing its credit exposure to a higher-risk borrower and increasing its exposure to an A-paper borrower.
More complex methods to limit credit exposure include purchasing credit default swaps, which effectively transfer credit risk to a third party. The swap buyer makes premium payments to the seller, and the seller agrees to assume the risk of the debt and compensate the buyer with interest payments – and return his premiums – if the borrower defaults. Credit default swaps played a major role in the financial crisis of 2008, as sellers misjudged the risk of the debt they were assuming when issuing swaps on bundles of subprime mortgages.
Credit Exposure vs. Credit Risk
The terms "credit exposure" and "credit risk" are often used interchangeably. Actually, credit exposure is one component of credit risk. It measures the potential magnitude of loss if a default occurs. The probability of default measures how likely it is the borrower is unable or unwilling to repay the debt. The recovery rate quantifies the portion of the loss likely to be recovered through bankruptcy proceedings or other collection efforts.