The credit limits concept forms the root of the credit risk management practice at most organizations around the world. Financial, as well as non-financial organizations, use this practice since it has been recommended by the Bank of International Settlements in its Basel Accord.
In reality, a lot of time, money, and resources are spent in coming up with a credit limit. The services of a credit analyst are required. The credit analyst then needs to gain access to the financials of the proposed debtor after which they make recommendations to the senior management. The end result is that a credit limit is decided.
The credit limit is a means to limit exposure to a particular debtor. Hence, it has to be defined in terms of credit exposure. There are different types of exposure that can be used to define this limit. In this article, we will have a look at the different types of exposure and how they differ from each other.
- Gross Exposure: This is the absolute amount at risk from the transaction. This is the amount that the firm would lose in case the worst-case scenario were to actually materialize. For instance, if a firm sells another firm goods worth $500 and receives a corresponding promissory note for $500, the worst that could happen is that the firm would not receive any payment and lose the entire $500.
A common mistake is to not include the time dimension when measuring gross exposures. This is because if the same loan is made for two years, it will be riskier as compared to a one-year loan even if the credit risk profile does not change over time. Many companies have therefore started adjusting the gross exposure amount with a time factor to make the results more palatable.
- Potential Exposure: In certain cases, particularly those related to financial institutions, the potential exposure can be more than the gross exposure. This is because the gross exposure for a bank would be the principal amount that they stand to lose in case the loan is not paid back. However, the bank is also likely to lose the money that they would have earned in interest. Hence, this amount is included in another metric called potential exposure. Any fines or penalties that might accrue due to delayed payment should also be included in the potential exposure value.
- Net Exposure: It is common practice for many debtors to provide some sort of collateral before they can avail themselves credit. If the value of this credit is reduced from the gross exposure, then the net exposure is derived. This is the most likely scenario which may materialize if a default takes place. This is because, in case of a default, the lender will gain access to the collateral and sell it to recover a part of the dues. It is only the leftover part i.e the net exposure will be at risk.
However, organizations must be careful while calculating the value of the collateral.
Securities used as collateral may be easier to dispose off since there is a liquid market and their price is easier to determine. On the other hand, real estate may be difficult to liquidate. If the value of the security is not known, then a conservative value must be used after deducting a haircut. Lenders also have to ensure that the value of the collateral is not correlated to the value of the underlying exposure otherwise it would become worthless in the event of a default.
- Adjusted Exposure: There are many cases in which borrowers have been granted high credit limits. However, in normal circumstances, they do not utilize all of this limit. This is observed in cases of revolving credit products like overdrafts.
Companies may have an overdraft facility of $10,000 but they may only use $2000 on average. In such cases, it is prudent for the lender to adjust their exposure based on the amount of credit that is actually extended instead of focusing too much on a notional amount. Hence, adjusted exposure is calculated by finding out the average utilization of a credit facility over a period of time. This is called Usage given default (UGD).
Hence, if a default occurs, it is likely that this amount will be outstanding and hence it should be considered while making decisions related to credit risk management. However, this limit should be monitored in a timely manner. This is because it is also possible that just before default, the organization may get desperate for cash and start utilizing all the credit at their disposal. If this is the case, then the exposure will rise rapidly and the company will not have an opportunity to limit its losses.
Hence, there are multiple ways to calculate exposure for the same client and the same transaction. It is up to the organizations to decide which method would be more appropriate to use in their calculations.
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