What is credit risk?

Credit risk is the risk or potential of loss that may occur due to failure of borrower/counterparty to meet the obligation on credit terms and conditions of financial contract. In this competitive ever changing business scenario there is uncertainty even with borrowers with highest credit quality (AAA corporate). This uncertainty associated with timing and amount of cash flows is a major risk to banks profitability. The key strategy is to identify measure and control this risk. Credit risk management involves monitoring, managing, controlling and mitigating risks so that banks can optimally utilize the capital and improve their profitability.

Credit risk is mainly of three types:

1. Default risk arising when the borrower is not able to make contractual payments.

2. Downgrade/Spread risk resulting from the downgrades in the risk rating of an issue

3. Credit spread risk occurring due to volatility in the difference between investments’ interest rates and the risk free return rate.

In corporate banking, risks are associated with the customized banking services banks provide to medium to large-sized corporate. Credit risk in corporate involve risk associated with corporate funding; project finance and fee based advisory roles.

There have been some traditional credit risk measurement techniques which include judging credit quality of borrower by your credit expert at bank , credit rating systems (CRISIL , ICRA do that) etc. For measurement of credit risk RBI has suggested banks to implement Internal Rating Based (IRB) approach. Banks now usually use more advanced approaches such as Foundation Internal Ratings Based approach (FIRB) and Advanced Internal Ratings approach (AIRB). The standardized approach is based on external ratings of corporate, the internal rates which are based on bank's internal ratings. This approach has three risk components which form of the basis of computing of expected and unexpected loss of credit risk. These are calculating probability of default (PAD), exposure at default (EAD), loss given default (LGD, calculated percentage of EAD). These tools and techniques are decided by the management of a bank to monitor, control and minimize credit risk.