Credit Risk

Credit risk is the risk that a counterparty will fail to meet his payment obligation, resulting in a loss. This risk is historically considered the main risk for banks. Under BIS II a bank should asses its credit risk and retain capital for it.


A bank is a financial intermediary that accepts deposits and channels those deposits into lending activities, either directly or through capital markets. A bank connects customers with capital deficits to customers with capital surpluses.

Synonyms: Banks

Bankruptcy is a legally declared inability or impairment of ability of an individual or organization to pay its creditors. Creditors may file a bankruptcy petition against a business or corporate debtor ("involuntary bankruptcy") in an effort to recoup a portion of what they are owed or initiate a restructuring. In the majority of cases, however, bankruptcy is initiated by the debtor (a "voluntary bankruptcy" that is filed by the insolvent individual or organization).

Synonyms: Bankruptcy

BIS stands for the “Bank for International Settlements” and is located in Basel. It was founded in 1930 during the aftermath of world war one. Its task was to regulate the reparation payments from Germany. This initial task of collection administration and distribution of money gave the bank its name. Besides this task the bank stimulated the development of and cooperation between central banks.


BIS I stands for the first capital accord that stated a minimum amount of equity (tier capital) for banks. Basically 8% (and sometimes 4%) of a loan should be retained as capital (Equity).

Synonyms: Basel 1, Basel I, BIS 1, BIS1, BISI

BIS II stands for the second capital accord that states a minimum amount of equity (tier capital) for banks. The accord is more risk sensitive than the first one. It allows banks to make their own estimate of the risk.

Synonyms: Basel 2, Basel II, BIS 2, BIS2, BISII

The credit conversion factor (CFF)translates an off balance sheet exposure to its credit exposure equivalent. Off balance sheet exposures (like a guarantee) has a probability of becoming a credit exposure and shifting onto the balance sheet (if the guarantee is called). The CFF is an estimate of this probability. By multiplying the CFF with the net value of the guarantee you get the expected value of the credit exposure.

See also: subordinate Synonyms: credit conversion factor

A claim on assets of value, which may be liquidated (sold) if a counterparty does not meet its payment obligations. The terms under which collateral may be liquidated (used) depend on the contract and will vary from country to country.

See also: Guarantee, haircut, LGD, Mitigation, subordinate, unpledged assets Synonyms: Mitigation

From a BIS II perspective corporate are companies that are not: Sovereigns; Non-central government public sector entities (PSE’s); Multilateral development banks (MDB’s); Banks; Security firms; Retail counterparties.
The most important division is between corporate and retail. A company is corporate if it has an exposure of more than one million Euro’s.

See also: Retail Synonyms: Corporates
credit derivatives

a credit derivative is a derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself.

credit risk

Credit risk is the risk that a counterparty will fail to meet his payment obligation, resulting in a loss. This risk is historically considered the main risk for banks. Under BIS II a bank should asses its credit risk and retain capital for it.

See also: EaD, EC, EL, PD, RC, UL

Exposure at Default (EAD) is an estimation of the extent to which a bank may be exposed to a counterparty in the event of, and at the time of, that counterparty’s default.

See also: credit risk, EL, LGD, PD, UL Synonyms: Exposure at Default

Economic Capital (EC) Besides the minimum Regulatory Capital (RC) banks are obliged to calculate their own assessed required capital, incorporating additional risks which are not properly defined in the BIS II accord (such as interest rate risk). The banks own calculation of the required capital (including additional risks) is generally called the Economic Capital.

See also: credit risk, EL, RC, UL Synonyms: Economic Capital

Expected Loss (EL) is the expected value of the loss on an counterparty or portfolio of counterparties. The expected loss (EL) is equal to the Probability of Default (PD) times the Loss Given Default (LGD) times the Exposure at Default (EaD):

See also: credit risk, EaD, EC, LGD, PD, UL Synonyms: expected loss

A comp[any or person who agrees to fulfil the payment obligation (at least in some part) if the counterparty fails to do so. The level of guarantee (full or partial) and the definition of payment failure are contract specific.

See also: Collateral, haircut, LGD, Mitigation, subordinate, unpledged assets Synonyms: Guarantees

Taking a haircut means, decreasing the value (of for instance collateral) used in the risk calculations. A haircut is used if the actual value generally received, is lower than the book value used as input for the calculations.

See also: Collateral, Guarantee, LGD, Mitigation, subordinate, unpledged assets Synonyms: haircuts

Internal Rating Based (IRB) approach. A system of determining solvency requirements in which a bank may use its own models to estimate the risk. A central bank will audit the performance of the model.

See also: Standardized approach Synonyms: Internal Rating Based

Loss Given Default (LGD) is the credit loss incurred if an obligor defaults, presented as a percentage of the Exposure at Default (EaD).

See also: Collateral, EaD, EL, Guarantee, haircut, Mitigation, PD, subordinate, UL, unpledged assets Synonyms: Loss Given Default

A good ability to fulfill short term financial obligations. A company has a good liquidity if its liquid assets are worth more than its short term liabilities. This means that a company is able to generate more money (by selling liquid assets in the short run) than it needs (for paying its short term liabilities). This also means that some of the liquid assets need to be paid with long term loans.

Synonyms: liquid
Liquidity crisis

Banks create liquidity. They do this by borrowing money in the short run and lending it for the long run. By doing this they absorb a certain risk. They run the risk that they cannot repay their short term obligations if they cannot find someone willing to refinance them. The risk of failing to raise capital and repay its creditors is the liquidity risk. The current crisis is caused by liquidity risk. Investors were unwilling to refinance banks.

Synonyms: Credit crisis, crisis, crisis, Financial crisis

The date on which a debt becomes due for payment, or the time it takes before a debt reaches this date.


Robert Carhart Merton (born 31 July 1944) is an American economist, university professor and Nobel laureate in economics.

See also: Vasicek

Reducing risk. In Credit Risk this is often synchronous to collateral.

See also: Collateral, Guarantee, haircut, LGD, subordinate, unpledged assets Synonyms: collateral

The Probability of Default (PD) is the likelihood that a loan will not be repaid and will fall into default.

See also: credit risk, EaD, EL, LGD, UL Synonyms: Probability of Default

Regulatory Capital (RC). This term is used to refer to the available capital (Tier capital) and to the required capital. The required legal minimum capital is calculated using the rules in the BIS II accord.

See also: credit risk, EC Synonyms: Regulatory Capital

To be included in the regulatory retail portfolio, claims must meet the following four
???Orientation criterion ? The exposure is to an individual person or persons or to a small business;
???Product criterion ? The exposure takes the form of any of the following: revolving credits and lines of credit (including credit cards and overdrafts), personal term loans and leases (e.g. instalment loans, auto loans and leases, student and educational loans, personal finance) and small business facilities and commitments. Securities (such as bonds and equities), whether listed or not, are specifically excluded from this category. Mortgage loans are excluded to the extent that they qualify for treatment as claims secured by residential property.
???Granularity criterion ? The supervisor must be satisfied that the regulatory retail portfolio is sufficiently diversified to a degree that reduces the risks in the portfolio, warranting the 75% risk weight. One way of achieving this may be to set a numerical limit that no aggregate exposure to one counterpart28 can exceed 0.2% of the overall regulatory retail portfolio.
???Low value of individual exposures. The maximum aggregated retail exposure to one counterpart cannot exceed an absolute threshold of €1 million.

See also: Corporate
Standardized approach

Standardized approach. A system of determining solvency requirements in which a bank standard risk assessments for customer types and product types. The standard risk assessments (risk weights) are given in de BIS II accord.

See also: IRB

A is subordinated if it ranks after other debts should a company fall into receivership or be closed.

See also: CFF, Collateral, Guarantee, haircut, LGD, Mitigation, unpledged assets Synonyms: subordinated
Tier one

Tier one capital is capital without any (or very few) strings attached.
Basically it contains the banks equity (Issued and fully paid ordinary shares/common stock and non-cumulative perpetual preferred stock, excluding cumulative preferred stock). Additionally some forms of mezzanine capital with properties like equity, can be recognised as tier one capital by your central bank.

See also: Tier three, Tier two Synonyms: tier 1
Tier three

Tier three capital consists of short term subordinated debt. A bank may only use for covering market risk after the central banks consent (it is a t the central banks discretion). The capital covering the market risk should consist of at least 28.5% tier one capital. The remainder may be tier two or three. Although the total tier two capital must remain equal or les than the tier one capital. Some central banks may require the sum of the tier two and three capital to be less or equal to the tier one capital. This is at the discretion of the central bank.

See also: Tier one, Tier two Synonyms: tier 3, tier3
Tier two

Tier two capital is capital with either some string attached or some difficulties considering its value.
Basically it contains the banks undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt (with a minimum term to maturity of 5 years for BIS 2). There may not be more tier two capital than tier one capital. Excess tier two capital will not be excepted as an eligible buffer

See also: Tier one, Tier three Synonyms: tier 2

Unexpected Loss (UL) is the expected value of the loss on an counterparty or portfolio of counterparties given a downturn (very bad) economic situation.

See also: credit risk, EaD, EC, EL, LGD, PD Synonyms: Unexpected Loss
unpledged assets

Assets that have not been put up for collateral to any creditor.

See also: Collateral, Guarantee, haircut, LGD, Mitigation, subordinate

Oldrich Alfons Vasicek (Old?ich Vaší?ek) (1942-) a Czech mathematician, received his master's degree in math from the Czech Technical University, 1964, and a doctorate in probability theory from Charles University four years later.

See also: Merton