What are the key indicators of credit risk in banks? (2024)

The probability of default (PD) is the likelihood that a borrower or a counterparty will default on a loan or an obligation within a given time horizon, usually one year. PD is estimated based on historical data, credit ratings, financial statements, market information, and other factors. PD is a key input for measuring the expected loss (EL) of a loan, which is the product of PD, exposure at default (EAD), and loss given default (LGD). PD is also used to assign risk weights to different types of loans and counterparties, which affect the capital requirements and the risk-adjusted return on capital (RAROC) of the bank.

The non-performing loans ratio (NPLR) is the percentage of loans that are past due or impaired, meaning that they are not generating interest income or principal repayment for the bank. NPLR is a measure of the quality and performance of the loan portfolio, as it indicates the level of credit losses and provisions that the bank has to incur. A high NPLR implies that the bank has a high credit risk exposure and a low asset quality, which may affect its liquidity, profitability, and solvency. NPLR is calculated by dividing the amount of non-performing loans by the total amount of loans.

The loan loss provision ratio (LLPR) is the percentage of loans that the bank has set aside as provisions to cover potential credit losses. LLPR is a measure of the adequacy and prudence of the bank's credit risk management, as it reflects the bank's assessment of the expected and unexpected losses of its loan portfolio. A high LLPR implies that the bank has a conservative approach to credit risk and a high coverage ratio, which is the ratio of provisions to non-performing loans. A low LLPR implies that the bank has a risky or optimistic approach to credit risk and a low coverage ratio, which may expose the bank to higher losses in the future. LLPR is calculated by dividing the amount of provisions by the total amount of loans.

Concentration risk is the risk that the bank's credit risk exposure is concentrated in a single or a few borrowers, sectors, regions, or products, which increases the potential impact of a default or a downturn on the bank's financial position. Concentration risk reduces the diversification and resilience of the bank's loan portfolio and exposes the bank to higher correlation and contagion effects. Concentration risk can be measured using various indicators, such as the Herfindahl-Hirschman index (HHI), the Gini coefficient, the Lorenz curve, and the exposure to the largest borrowers or sectors.

Credit risk stress testing is the process of assessing the impact of adverse scenarios on the bank's credit risk exposure and capital adequacy. Credit risk stress testing helps the bank to identify and quantify the potential losses and vulnerabilities of its loan portfolio and its counterparties under different economic and market conditions. Credit risk stress testing also helps the bank to evaluate the effectiveness of its credit risk mitigation techniques, such as collateral, guarantees, hedging, and diversification. Credit risk stress testing is usually conducted using historical or hypothetical scenarios, sensitivity analysis, or Monte Carlo simulation.

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