5.4.1 The Basel approach to credit risk

206. Credit risk can be seen as the risk that an institution will not receive the monies it is owed by its creditor. Gleeson summarizes credit risk as “the risk that a counterparty will fail to perform fully its financial obligation”.1 The Joint Forum of the Bank for International Settlement adds to this definition that it “can arise from multiple activities across sectors. For example, credit risk could arise from the risk of default on a loan or bond obligation, or from the risk of a guarantor, credit enhancement provider or derivative counterparty failing to meet its obligations”.2 As Gleeson states, “credit risk is a risk faced by all business” and not just financial institutions such as banks and investment firms.

207. The term credit risk in prudential regulation covers a broader set of underlying risks:3 (1) credit risk, which covers the exposures that are not part of an institution’s trading book,4 including those arising from direct lending; (2) counterparty credit risk, which covers exposures arising from (i) transactions in a firm’s trading book and (ii) transactions not settled after their due delivery date in both a firm’s trading book and non-trading book (commonly termed “settlement risk”); (3) concentration risk – where material groups of exposures are subject to the same underlying risk factors, e.g. sectoral, geographical.

208. Credit risk measurement, therefore, focuses on the exposures of a firm incurring credit risks. These exposures will usually materialize through a balance sheet item. Banks with an active loan portfolio are thus the primary types of institutions which are subject to credit risk. Investment firms engaging in granting investment credit, as discussed in Chapter 2.1.3, will also be subject to credit risk.