Coping with Credit Risk

Abstract

Credit risk is pervasive throughout financial markets. Traditionally, various financial institutions have assumed the burden of credit risk. Banks have supported the credit risk attached to bank loans and forward contracts. Credit insurance companies have provided coverage for the commercial credit risk faced by suppliers of consumer and investment goods and services. Public insurers, such as the ECGD in the UK, have specialized in the coverage of credit risk attached to export trade and overseas investment. Specialized institutions, such as factoring companies, have offered credit risk coverage as one component in a basket of financial services. More recently, the proliferation of financial contracts that entail counter-party default risk - such as swaps, back-to-back loans, and derivative products - have focused attention on ways to deal with credit risk in the marketplace. New products, such as credit default swaps, credit spread options and total-rate-of-return swaps, have allowed firms and financial institutions to more effectively deal with credit risks. Indeed, a recent survey by the British Banker's Association estimates the current market for credit derivative to be around $900 billion in notional principal, with that amount expected to jump to over $1.5 trillion in 2002. In addition, insurance markets have reacted with an array of new products, many with the backing of larger capital markets, such as insurance-linked securities and finite-risk contracts (Shimpi 1999).