A regional bank originated a $50 million corporate term loan at par. The borrower kept paying interest, but its leverage doubled in twelve months and its rating slid two notches. No default has occurred. Has the bank lost money? On a mark-to-market book the answer is yes: credit risk is loss of value, not just loss from default. Distinguishing those two views drives every governance decision that follows.
Credit risk is the risk that a counterparty fails to perform on a contractual obligation OR that the value of that obligation falls because the counterparty's creditworthiness deteriorates. The first view is default-mode: nothing matters until the loan stops paying. The second view is mark-to-market: a downgrade from BBB to BB drops the bond's price even when no default occurs, and that price drop is a real loss to a trading-book holder.
Banks running banking-book accounting tend to think default-mode. Banks running trading-book accounting must think mark-to-market. Most large banks run both, which is why credit-portfolio models like CreditMetrics simulate rating migrations rather than default-only outcomes.
Common mistakes
- Treating insolvency, default, and bankruptcy as synonyms. The exam tests the distinctions. Insolvency is balance-sheet, default is contractual, bankruptcy is legal. A choice that says "the firm defaulted, therefore it is bankrupt" is wrong. Trap: a question describes a covenant breach with no missed payment and asks if a default has occurred.
- Using EL as the capital number. EL is absorbed by spread and reserves; capital absorbs UL. A choice that recommends "hold capital equal to PD × LGD × EAD" is wrong. Trap: a question gives PD, LGD, EAD and asks for capital. The right answer involves a confidence-level VaR or UL multiple, not EL.
- Treating the three lines of defense as a sequence. The lines operate simultaneously, not sequentially. The first line owns risk, the second line challenges it concurrently, and the third line audits both.
Bottom line
- Credit risk is loss from a counterparty failing contractual obligations OR from credit-quality deterioration short of default. Default-mode views one; mark-to-market views both.
- Insolvency, default, bankruptcy are not synonyms. Insolvency is a balance-sheet condition; default is a contractual breach; bankruptcy is a legal proceeding.
- Three lines of defense are concurrent, not sequential: business owns risk, independent risk management challenges it, internal audit verifies both. Credit committee approves transactions above delegated limits.
- Expected loss is priced into spreads and absorbed by reserves. Unexpected loss is volatility around EL, absorbed by economic capital.
Exam shortcut
When a question gives you PD, LGD, EAD and asks for "the loss the bank expects," the answer is the product. When it asks for "capital" or "the loss at confidence c," reach for UL or Vasicek (CR3), never EL. When a question describes a bank's risk function reporting into the business it covers, that is a three-lines-of-defense violation regardless of how the choices are worded.
The full lesson (about 3,053 words, 20 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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