Credit risk – the risk that a borrower may not repay the loan, and the lender might lose the principal amount and/or the interest.
Pay attention, credit risk management newbies: the expected loss equals the probability of default times the exposure at default times the haircut.
Now you may say: “What?!” But that’s only because you haven’t listened to this week’s episode of the European Investment Bank’s podcast ‘A Dictionary of Finance’. In it, EIB credit risk management officer Gabriela Manciu explains everything eloquently:
- The probability of default, meaning the chance of the borrower going bust
- Exposure at default, which is how much they owe you when they go bust
- Haircut, meaning how much of it you are not likely to recover (by claiming collateral, for example). This is also known as “loss given default.”
The first bit, the probability of default, is perhaps the most difficult to estimate, and often takes the form of a credit rating. This can be done by a bank internally (it has probably been done to you, if you’ve ever taken out a credit card or a mortgage), or publicly by ratings agencies such as Fitch, Moody’s and Standard & Poor’s.
The rating takes into account both the company and its broader operating environment, including what we call the country (or sovereign) risk.
Gabriela also explains how credit risk is then managed by banks, through pricing of the financial products offered to the borrowers with various credit risk profiles and through the covenants included in the loan contracts. These include concepts such as pari passu, cross default, material adverse events, negative pledge etc.
It turns out these legal clauses in the financing contracts are not there just so a bank can call a loan home quickly in case something happens. They are there to ensure we get a seat around the table to discuss the best course of action, which could hopefully see the borrower survive, and the lender get its money back (also known as restructuring).
While you’re at the table you might also get a piece of the club deal being handed around – but I’m not going to tell you what that is, you’ll have to listen to the episode.