Credit risk

The uncertainty a lender takes on when issuing credit, based on the chance that a borrower may fail to repay and cause a financial loss.

This risk exists in any lending decision where repayment depends on the borrower’s ability and willingness to meet their obligations.

In practice, credit risk is the possibility that expected cash flows from a loan will not arrive in full or on time.

Example

When a bank issues a loan, it takes on credit risk because the borrower may miss payments or default. To reduce that risk, lenders assess credit scores, review credit history, and evaluate debt-to-income ratios to judge the borrower’s creditworthiness. They may also require collateral or charge higher interest rates when the perceived risk is higher.