Credit risk
The risk that your counterparty will go bankrupt.
The classic example of a credit risk is a bank deposit, although the JC has known credit officers[1]to express surprise at this assertion.
If you give your money to a bank, contrary to popular opinion, it does not put it in its safe in a special tin labelled with your name. It will use the money you have given it - which is now its money, not yours[2]- to fund its operations, and make money for itself. It will lend the money to other counterparties, amdtthus become a creditor. You become a creditor of the bank - an unsecured creditor, to be precise - under a deposit contract. It owes you the money (and interest), but if the investments it makes go bad, the risk remains it will not be able to repay your deposit.
This is rare, but it dies happen. Remember those queues outside Northern Rock?
This risk is called credit risk. Banks are prudentially regulated to make this risk lower - they have to keep a buffer of regulatory capital in free cash, and there are certain measures they must take to ensure they do not themselves have large exposures to other counterparties.
- ↑ Who, one would like to think, are not long for this employment.
- ↑ This is a frequently misunderstood point, even by credit officers. When you give money to the bank (or anyone else) it is no longer your money. The bearer for the time being of cash owns it absolutely against all other claims. Instead, you have a debt claim for the payment of that amount of cash. You are a creditor.