The quantification of credit risk is the process o🃏f 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.

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 riꩲsk, 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 澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询:macroeconomic considerations, suc𝓀h as economic growth and interest raܫtes.

The three most widely used measures assoc♋iated with credit risk are: probability of defa꧑ult, loss given default, and exposure at default. Here is how each of those works:

Probability of Default

The 澳洲幸运5开奖号码历史查询: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: 澳洲幸运5开奖号码历史查询:debt-to-income ratio and 澳洲幸运5开奖号码历史查询:credit score.

澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询:bankruptcy proceedings.

Exposure at Default

Similar in concept to LGD, 澳洲幸运5开奖号码历史查询: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 u🎃sed 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 澳洲幸运5开奖号码历史查询:lines of credit, risk exposure estimates should include not just current balances, but also the potential increase in the 澳洲幸运5开奖号码历史查询:account balances that might happen before the borrower defaults.

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 borrowe✅r is likely to have to pay for a loan if they qualify for one at all.