Credit Risk
What the exam tests
This domain tests how credit risk is assessed, measured, mitigated and provisioned. Expect the five Cs, PD LGD EAD, expected loss, collateral and covenants, concentration risk and IFRS 9 staging.
Core rules and concepts
- Credit risk is the risk that a borrower or counterparty fails to meet its obligations. It includes default risk, downgrade risk, settlement risk and country risk.
- The five Cs of credit: character (willingness and track record), capacity (ability to repay from cash flow), capital (equity cushion), collateral (security) and conditions (economic and industry context). Some frameworks add covenants or control.
- Expected loss = PD x LGD x EAD. PD is the probability of default over a horizon; LGD is the share lost if default occurs; EAD is the exposure at default, including undrawn commitments.
- Unexpected loss is covered by regulatory and economic capital; expected loss is covered by pricing and provisions.
- Credit scoring uses application and behavioural scorecards with cut-off scores. It is statistical, so it needs validation and monitoring for drift.
- Mitigation includes collateral (with valuation, haircuts and legal enforceability), guarantees, credit derivatives, netting and covenants. Mitigation reduces LGD but can create wrong-way risk if the guarantor is correlated with the borrower.
- Concentration risk arises by single name, sector, product or geography. Large exposures rules limit single-counterparty exposure.
- Counterparty credit risk arises on derivatives and securities financing; measures include current exposure, potential future exposure and CVA.
- IFRS 9 provisions: stage 1 (12-month expected credit loss), stage 2 (lifetime ECL after significant increase in credit risk), stage 3 (credit-impaired). Provisions are forward-looking and not the same as regulatory capital.
Worked example
A corporate loan has drawn balance £9.5m, undrawn commitment £0.5m, PD 1.5% and LGD 40%. EAD is £10m if the full commitment is expected to be drawn; expected loss = 0.015 x 0.40 x £10m = £60,000. If an enforceable guarantee covers 50% of the exposure and the guarantor is strong, LGD may fall to 20%, giving £30,000. But if the guarantor is in the same industry as the borrower, wrong-way risk means the guarantee may fail exactly when needed. The bank should also check concentration limits and IFRS 9 staging.
Traps that cost marks
- Using the drawn balance as EAD and ignoring undrawn commitments.
- Assuming collateral eliminates credit risk. It reduces LGD but needs valuation, haircuts and legal enforceability.
- Confusing PD with the default rate observed in a portfolio. PD is forward-looking.
- Treating IFRS 9 provisions as regulatory capital. They are accounting provisions.
- Ignoring wrong-way risk and concentration risk in mitigation.
- Forgetting that a guarantee transfers risk only if the guarantor performs.