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Credit risk is the risk of a borrower defaulting on a loan, or related financial obligation.
Banks use credit risk modelling to calculate the amount of capital to hold against credit losses. There are two types of losses: expected and unexpected.
Banks provision for expected losses under the global accounting standard IFRS 9. This requires banks to set aside reserves to cover losses at the point that the loan is originated or purchased. The previous accounting standard, IAS 39, required banks to provision for losses only at the point the loan showed signs of credit deterioration. The US has its own version of IFRS 9 known as CECL.
The regime for unexpected losses is the Basel capital accords. Set and maintained by the Basel Committee on Banking Supervision, the rules require banks to hold a minimum level of capital against their total RWAs. Under the latest Basel III regime, firms calculate credit risk capital either using a regulator-set, standardised method, or using their own models, known as the internal ratings-based approach.
Credit risk is distinct from counterparty credit risk (also termed counterparty risk), which is the risk of a financial counterparty defaulting before it has completed a trade.
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