What Is Credit Exposure?
Credit exposure refers to the total amount of credit that a lender avails to a borrower. The magnitude of credit exposure indicates the extent to which the lender is exposed to the risk of loss, in the event that the borrower defaults on the loan. Credit exposure can be minimized through purchasing credit default swaps and other types of financial instruments.
Understanding Credit Exposure
Credit exposure is the maximum amount of money that will be lost if the counterparty to a contract defaults on a loan. For example, if a bank has made short-term and long-term loans totaling $100 million to company A, its credit exposure to that business is straightforwardly $100 million.
Banks generally seek to maximize their credit exposures to customers with high credit ratings, while minimizing their exposure to clients with lower credit ratings. If a customer encounters unexpected financial problems, a bank may seek to reduce its credit exposure in an attempt to mitigate the risk of loss that may arise from a potential default.
Banks may look at the totality of loan activities with a given customer when analyzing credit exposure; a consumer that has made timely payments on both his car loan and his mortgage, for example, may have an easier time receiving approval on a personal loan application.
How Lenders Control Credit Exposure
Lenders have numerous methods of controlling credit exposure. Certain practices are simple, such as a credit card company setting credit limits, based on its evaluation of a borrower's likely ability to repay the sum owed. For example, it's logical for a credit card company to impose a $300 credit limit on a college student with no credit history until he or she demonstrates a proven track record of making on-time payments.
At the other end of the spectrum, the same credit card company may be strategically justified in offering a $100,000 limit to a high-income customer with a FICO score above 800. In the first instance, the card company is reducing its credit exposure to a higher-risk borrower. In the latter scenario, the company is shrewdly 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, who agrees to assume the risk of the debt, and compensate the buyer with interest payments—while also returning 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 is a term used to describe the extent to which the lender is vulnerable to a potential loss if a borrowing counterparty defaults on a loan.
- Credit card companies mitigate risk my offering differential credit limits to different consumers based on their likely ability to make timely payments on their debts.
- Other methods of reducing credit exposure include the use of credit default swaps, in which a third party effectively absorbs the credit risk.
Credit Exposure vs. Credit Risk
The terms "credit exposure" and "credit risk" are often used interchangeably. But in actuality, credit exposure is a component of credit risk, that measures the potential magnitude of loss if a default occurs.
The probability of default measures how likely the borrower will be 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.