Credit Risk

Aditya Kumar Pandey
2 min readJul 6, 2020

Everyone used to hear about the credit risk in his daily life, especially people who are working in finance, banking, or people who are working as a business analyst. So what is this credit risk? How does it occur? Well, let us understand this with the definition of credit risk.

Credit risk is the risk where the borrowers fail to repay his debt or fail to make the required payment which he had borrowed from the bank. Let suppose that you want some money to establish your business, so how will you get that? one of the options is that you can borrow the money from the bank. when you borrowed money from bank, after that you need to repay that money back to the bank with some interest(interest is the amount you pay for borrow the money). Now here is the risk that whether you will be able to return the money back to the bank or not, this is called the credit risk.

The other thing you can do is that you can reach to a partner and in order to give you the money the partner will ask you about some share of your business which you need to give him. This is called Equity.

Understanding Credit Risk

Let us understand the credit risk with respect to a bank. you may know that a bank takes money from depositors, depositors are the source of money for the bank. The bank lends this money to the borrowers. The bank expects that they will get back that money with some interest from the borrowers. The bank pays the money to the depositors from the interests. Now there is the difference between the interest rate between the depositors and the borrowers and this is how the bank makes the money. Here is the risk generated with the borrowers. The bank wants his money back from the borrowers, but there is the chance that the borrowers may not repay the money with interest. This is called credit risk.

Aspects Of Credit Risk

There are three aspects of credit risk.

  • Probability of response(PD)
  • Exposure at Default(EAD)
  • Loss Given Default(LGD)

Probability of List(PD): It is defined as what is the probability that the borrower will pay his debt. It is the chance of paying the money back to the bank.

Exposure at Default(EAD): It is defined as what is the chance that the individual will not pay the money and if he is not paying the money, then how much money is at risk?

Loss Given Default(LGD): This means that if the bank came to know that the individual will not pay his money, then the bank will put all his possible efforts to take his money back.