Credit Exposure

What Is Credit Exposure?

Credit exposure is a measurement of the maximum expected loss to a lender in the event that the borrower defaults on payment. It is a calculated risk to carrying on with work as a bank.

For instance, assuming that a bank has made a number of short-term and long-term loans adding up to $100 million to a company, its credit exposure to that business is $100 million.

Figuring out Credit Exposure

Banks look to limit their credit exposures by stretching out credit to customers with high credit ratings, while at the same time keeping away from clients with lower credit ratings.

Assuming that a customer experiences startling financial issues, a bank might look to reduce its credit exposure to relieve the loss that might emerge from a potential default. For example, a credit card client who misses a payment might be forced to pay a penalty fee and a higher interest rate on future purchases. This practice reduces the overall credit exposure to the card issuer.

How Lenders Control Credit Exposure

Lenders have a number of ways of controlling credit exposure. A credit card company sets credit limits in view of its evaluation of a borrower's probable ability to repay the sum owed.

For instance, it might impose a $300 credit limit on a college student with no credit history until the person has a proven history of making on-time payments. A similar credit card company might be justified in offering a $100,000 limit to a high-pay customer with a FICO score over 800.

In the main occurrence, the card company is decreasing its credit exposure to a higher-risk borrower. In the last scenario, the company is sustaining its business relationship with a rich client.

Credit Default Swaps

A more complex method of limiting credit exposure is purchasing credit default swaps. A credit default swap is an investment that really transfers the credit risk to an outsider. The swap buyer makes premium payments to the swap seller, who consents to assume the risk of the debt. The swap seller repays the buyer with interest payments, while additionally returning the premiums assuming that the borrower defaults.

Credit default swaps assumed a major part in the financial crisis of 2008, after sellers misconceived the risk of the debt they were assuming while giving swaps on heaps of subprime mortgages.

Credit Exposure versus Credit Risk

The terms credit exposure and credit risk are frequently utilized conversely. Nonetheless, credit exposure really is a part of credit risk.

The credit default swap was planned as a method for limiting credit exposure. It didn't resolve that way during the 2007-2008 financial crisis.

Different parts incorporate the probability of default, which gauges how likely it is that the borrower will not be able or reluctant to repay the debt, and recovery rate, which evaluates the portion of the loss that is probably going to be recuperated through bankruptcy procedures or debt assortment efforts.

Highlights

• Credit exposure is one part of credit risk.
• The credit rating system was made to assist lenders with controlling credit exposure.
• It shows the maximum loss to a lender on the off chance that a borrower defaults on a loan.