What Is Credit Exposure?
Credit exposure is a measurement of the maximum potential loss to a lender if the borrower defaults on payment. It is a calculated risk to doing business as a bank.
For example, if a bank has made a number of short-term and long-term loans totaling $100 million to a company, its credit exposure to that business is $100 million.
Understanding Credit Exposure
Banks seek to limit their credit exposures by extending credit to customers with high credit ratingswhile avoiding clients with lower credit ratings.
Key Takeaways
- Credit exposure is one component of credit risk.
- It indicates the maximum loss to a lender if a borrower defaults on a loan.
- The credit rating system was created to help lenders control credit exposure.
If a customer encounters unexpected financial problems, a bank may seek to reduce its credit exposure to mitigate the loss that may arise from a potential default. For instance, a credit card user who misses a payment may 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 to control credit exposure. A credit card company sets credit limits based on its evaluation of a borrower’s likely ability to repay the sum owed.
For example, it may impose a $300 credit limit on a college student with no credit history until the person has a proven track record of making on-time payments. The same credit card company may be justified in offering a $100,000 limit to a high-income customer with a FICO score above 800.
In the first instance, the card company is reducing its credit exposure to a higher-risk borrower. In the latter scenario, the company is nurturing its business relationship with a wealthy 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 effectively transfers the credit risk to a third party. The swap buyer makes premium payments to the swap seller, who agrees to assume the risk of the debt. The swap seller compensates the buyer with interest payments, while also returning the premiums if the borrower defaults.
Credit default swaps played a major role in the financial crisis of 2008, after sellers misjudged the risk of the debt they were assuming when issuing swaps on bundles of subprime mortgages.
Credit Exposure vs. Credit Risk
The terms credit exposure and credit risk are often used interchangeably. However, credit exposure actually is a component of credit risk.
The credit default swap was designed as a way to limit credit exposure. It didn’t work out that way during the 2007-2008 financial crisis.
Other components include the probability of defaultwhich estimates how likely it is that the borrower will be unable or unwilling to repay the debt, and recovery ratewhich quantifies the portion of the loss that is likely to be recovered through bankruptcy proceedings or debt collection efforts.