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 calculat💯ed 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 b🐼usiness is $100 million.

Understanding Credit Exposure

Banks seek to limit their credit exposures by extending credit to customers with high credit ratings, while avoiding clients with lower credit rat꧋ings.

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 𒁃pay 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 澳洲幸运5官方开奖结果体彩网:FICO score above 800.

In the first instance, the card company is reducing its credit exposure to a hig💛her-risk borrower. In the latter scenario, the company is nurturing its bu✃siness 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 w🏅ith 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 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:credit risk.

Other components include the probability of default, which estimates how likely it is that the borrower will be unable or unwilling to repay the debt, and 澳洲幸运5官方开奖结果体彩网:recovery rate, which quantifies the portion of the loss that is likely to be recovered through bꦬankruptcy proceedings or debt collect💙ion efforts.