Credit risk modelling for public institutions' investment portfolios

Introduction Credit risk may be defined as the potential that an obligor (borrower or counterparty) is unwilling or unable to meet his financial obligations in a timely manner. Credit risk is a dynamic and broad concept as it encompasses default risk (i.e. an obligor being unwilling or unable to repay his debt) as well as changes in the quality of the credit (e.g. a rating change). Credit risk in central banks comes from two sources. The first is related to policy operations and is discussed in Chapters 7 to 10. The second source of credit risk comes from investment activities, and is the topic of this chapter. Credit risk is the dominant source of financial risk in a typical commercial bank, whose traditional role is of an intermediary between lenders and borrowers. In contrast, and as illustrated by Table 1.3 in Chapter 1, the typical central bank has only a very limited exposure to credit risk, in particular when compared with currency and gold price risk. The picture for public institutions and also institutional investors is more mixed. For some of them, lending is a core activity, and their credit risk profile may resemble that of a commercial bank. Examples include the European Investment Bank (EIB) or the European Bank for Reconstruction and Development (EBRD). But for others, including (state) pension funds and sovereign wealth funds, credit is not necessarily a natural asset class and their exposures too tend to be rather modest.