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The possibility that a borrower or fails to meet a financial obligation.
Save conceptCredit risk is the possibility that a borrower or other will fail to meet an agreed financial obligation. A loan can create credit risk for its lender; a bond creates exposure to its issuer’s ability to pay. The risk includes both the chance of non-payment and how much the creditor may lose if it occurs.
Lenders assess repayment capacity, existing debt, income or cash flow, and other relevant information. They can limit exposure, price the risk and seek security. may reduce losses after default, but its value and enforceability matter. Diversification can reduce dependence on one borrower without eliminating losses across a shared industry or economic shock.
Suppose a lender advances J$1 million to a business. The business fails and the lender ultimately recovers J$600,000 from available security, after recovery costs already included in that figure. The loss is J$400,000. The amount originally lent, the probability of default and the likely recovery are different parts of understanding the exposure; did not make the loan risk-free.
Credit risk differs from temporary changes in an asset’s market price and from the lender’s own need for cash. A borrower can also pay late without causing the maximum possible loss. A strong or past payment record is useful information, but neither is a guarantee. Conditions, loan seniority and the legal recovery process affect what happens after a default.
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