CREDIT RISK definition in the Cambridge English Dictionary

credit risk definition

The PRA considers that to implement a specific ‘extraordinary circumstances’ condition is unnecessary, and therefore proposes to retain the existing conditions for reversion and apply these to both entire roll-out classes and subsets of exposures within roll-out classes. 4.64 The BCBS identified concerns regarding the extent to which certain exposure classes, particularly those containing low default portfolios, can be modelled robustly for the calculation of RWAs. 4.28 The PRA considers that the proposed timelines would advance the PRA’s primary objective of safety and soundness. The timelines would result in all IRB non-modelling changes being implemented by the PRA’s proposed implementation date, which would improve the robustness and risk capture of the IRB approach. In cases where model changes are not made by that date, firms would be required to assess whether PMAs would be appropriate to address any potential undercapitalisation of risk.

Credit default swaps are a type of credit derivative that allows parties to transfer credit risk by exchanging periodic payments for protection against a specified credit event, such as a default or credit rating downgrade. Financial performance, including a borrower’s revenue, profitability, and cash flow, can also influence credit risk. Lenders and investors must analyze a borrower’s financial performance to determine their capacity to meet their financial obligations. Credit risk can be influenced by a variety of factors, including borrower-specific factors and macroeconomic factors.

Credit Risk: Definition, Role of Ratings, and Examples

4.165 The Basel 3.1 standards set minimum data requirements for firms to adopt the IRB approach. These state that firms should use at least five years of data from at least one source to estimate all parameters, with the exception of LGD and EAD for non-retail portfolios where seven years of data is required. 4.148 In order to address the above considerations, the PRA proposes to remove the existing expectation and introduce a new requirement that firms using any of the IRB approaches would calculate an ‘unrecognised exposure adjustment’. The proposal would not require firms to calculate an unrecognised exposure adjustment where the amount of such exposures is immaterial.

  • For revolving exposures that are at or over limit, firms would be required to model EAD directly as the PRA considers that CFs are not a meaningful concept for on-balance sheet exposures.
  • This risk can be influenced by factors such as the quality of the collateral and the legal framework governing debt recovery.
  • The PRA proposes to include this provision in its rules as it considers this would be more appropriate than applying the requirement on a firm-by-firm basis as is currently the case.
  • In assessing risk limits, it makes sense to proceed by business unit, product, industry, and geography.
  • 4.248 The PRA proposes that firms using the alternative methodology would be required to estimate LGDU using an approved IRB model.

Where different modelling approaches would be applied to different exposure classes or sub-classes, this is assessed in the relevant section of this CP. 4.239 When recognising collateral in LGD estimates while using the AIRB approach, firms are currently required to establish internal requirements for collateral management, legal certainty, and risk management that are generally consistent with those set out in the CRM chapter of the CRR. The PRA proposes to retain this approach for firms using the LGD modelling collateral method subject to clarifying that the relevant CRM standards are those that apply to firms using the FIRB approach, in line with the Basel 3.1 standards. The PRA also proposes to clarify that collateral that does not meet these requirements should be classed as ‘ineligible’ for the purpose of applying the LGD modelling collateral method. 4.86 Similarly, the PRA considers that its proposal to remove modelling of central government, central bank, and equity exposures would be consistent with the principle that firms should be permitted to model exposures only where they can do so in a robust manner.

Definition of Credit Risk

However, the current combination of events is unprecedented, and the challenge cannot be finessed by simple tweaks to model parameters. The CRR and PRA rules use the term ‘exposure classes’ whereas the Basel 3.1 standards typically use the term ‘asset classes’. References to exposure classes in this CP should be read as having the same meaning as asset classes in the Basel 3.1 standards. 4.334 The PRA recognises that its proposals could potentially give rise to regulatory arbitrage whereby firms could choose to allocate certain exposures to either the other general corporates exposure sub-class or the specialised lending exposure sub-class in order to optimise RWAs.

4.220 The PRA therefore proposes to prohibit the use of continuous rating scales in PD models and to require firms to use discrete rating scales instead. 4.216 This section sets out the PRA’s proposals for PD estimation under the IRB approach to credit risk. For detail on the PRA’s proposals relating to PD input floors, please refer to the ‘Input floors’ section above. These floors would be flat (ie non-variable) LGD floors for unsecured and retail residential mortgage exposures, and variable floors for other fully or partially secured exposures.

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4.112 However, the PRA considers that one-off costs that relate to implementing the proposed requirements set out in this CP could occur and that, as a result, mandating firms to remain on either the FIRB approach or the AIRB approach could be unduly burdensome. Therefore, the PRA proposes to supplement the reversion conditions with expectations that it would consider one-off costs arising from implementing the requirements proposed in this CP as a relevant factor when it considers whether the conditions are met. 4.78 The Basel 3.1 standards allow a five-year linear phase-in arrangement for firms using the IRB approach to move equity exposures to the SA, in order to give firms additional time to adjust to the revised approach. The PRA proposes to introduce transitional arrangements that are in line with the Basel 3.1 standards. 4.41 The PRA proposes to extend the annual attestation expectation so that it also covers compliance with PRA rules and covers implementation of an appropriate remediation plan where relevant.

credit risk definition

4.283 The PRA currently has an expectation that enables firms to model EAD directly in place of the CF estimates that are required by the CRR. The PRA proposes to continue the substance of its existing approach but to formalise the approach into PRA rules. For revolving exposures that are at or over limit, firms would be required to model EAD directly as the PRA considers that CFs are not a meaningful concept for on-balance sheet exposures. The PRA proposes to make a number of related changes to its rules and expectations relating to the modelling of EAD and CFs. 4.280 The PRA considers that the proposed restrictions on modelling off-balance sheet exposures are appropriate as it considers firms’ existing modelling approaches for these exposures is inconsistent, resulting in unwarranted variation in EAD estimates between firms.

Permission to use the IRB approach

This expectation would be consistent with the PRA’s proposals that netting agreements would only be recognised through exposure values as set out in the Chapter 5, and would complement existing guidance regarding the calculation of realised LGDs. 4.200 In response to these concerns, PS16/21 introduced an expectation that firms apply a 10% UK retail residential mortgage portfolio-level risk weight floor, which has applied since 1 January 2022. 4.196 The proposed PD floors would apply to all exposures capitalised under the IRB approach (except for exposures subject to the slotting approach), and the LGD and CF floors would apply to exposures to which the AIRB approach is applied (the CF floors would not apply where CF modelling is not permitted). The input floors would apply to non-defaulted and defaulted exposures but would not apply for the purpose of calculating ‘best estimate of expected loss’. 4.168 In respect of the first proposal, the PRA currently expects PD estimates to reflect a representative mix of good and bad periods so that no additional data would be required in practice.

  • Each lender will measure the five Cs of credit (capacity, capital, conditions, character, and collateral) differently.
  • The proposals aim to reduce the prudential risk that firms’ IRB models do not adequately reflect risks and therefore result in underestimation of RWAs.
  • The PRA expects these permissions to be saved by HMT to avoid firms needing to re-apply for existing permissions.
  • Spread risk arises from fluctuations in the credit spread, which is the difference between the interest rate on a risky debt instrument and a risk-free debt instrument.


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