Own credit risk

What Is Own Credit Risk?

Own credit risk, a concept central to fixed income and financial risk management, refers to the risk that an entity will not fulfill its obligations to its bondholders or other creditors due to a deterioration in its own financial health. It is the risk that a company's own debt instruments will decline in value because the market perceives the company itself to be less creditworthy. This specific form of default risk is distinct because it focuses on the issuer's ability to repay its own liabilities, rather than the risk associated with a counterparty's failure to perform on a transaction.

History and Origin

The concept of own credit risk gained significant prominence in accounting and finance, particularly following the 2008 financial crisis, when financial institutions experienced severe declines in the fair value of their own liabilities as their creditworthiness deteriorated. Under certain fair value accounting standards, a decline in an entity's own credit standing would paradoxically result in an accounting "gain" on its liabilities because the market value of those liabilities decreased. This counterintuitive outcome spurred extensive debate among regulators, standard-setters, and financial professionals regarding the appropriate treatment of own credit risk in financial reporting¹⁹.

For instance, during the 2008 crisis, as major banks like Lehman Brothers faced collapse, the market value of their outstanding bonds plummeted, reflecting an increased perception of their own credit risk. While this reduced the carrying value of their debt on the balance sheet, thereby creating an accounting gain, it was a direct signal of severe financial distress¹⁸. Accounting bodies, including the Financial Accounting Standards Board (FASB), subsequently issued guidance to address this, notably through ASC 820 (formerly FAS 157), which requires entities to consider their own credit risk when fair valuing liabilities. This aimed to provide a more accurate and consistent representation of the entity's financial position, though the "gain" on deterioration in credit quality remained a point of contention for some¹⁷,¹⁶,¹⁵.

Key Takeaways

• Own credit risk refers to the possibility that an entity's liabilities will decrease in value due to a decline in its perceived creditworthiness.
• It is a key consideration in fair value accounting, particularly for liabilities that are measured at market value.
• A deterioration in an entity's own credit standing can lead to a counterintuitive accounting "gain" on its liabilities under fair value measurement, as the present value of future obligations decreases.
• Regulatory and accounting bodies have issued guidance to address the recognition and presentation of changes in own credit risk, often requiring these effects to be recognized separately.

Interpreting Own Credit Risk

Interpreting own credit risk primarily involves understanding how changes in an entity's financial health affect the valuation of its liabilities, especially those accounted for at fair value. When a company's financial condition deteriorates, its credit ratings may be downgraded, and the market demands a higher yield for its debt instruments. This higher yield implies a lower present value for the company's existing debt. Conversely, if a company's financial health improves, its debt becomes more attractive, yields fall, and the present value of its liabilities increases.

For example, if a financial institution issues a bond, and its own credit standing worsens, investors will demand a higher discount rate to hold that bond. This higher discount rate reduces the fair value of the bond on the issuer's balance sheet, leading to an accounting gain. While mechanically correct under fair value principles, this "gain" is not indicative of improved financial performance but rather a heightened perception of the issuer's default risk. Therefore, the interpretation must consider the underlying economic reality: a gain from own credit risk reflects a decrease in the market's confidence in the issuer's ability to pay, not an actual increase in economic value.

Hypothetical Example

Consider "Alpha Corp," a publicly traded company that issued \$100 million in fixed income bonds two years ago. At the time, Alpha Corp had a strong credit rating, and its bonds traded at par. Today, due to unforeseen economic challenges and increased liquidity risk in its sector, Alpha Corp's financial outlook has worsened, leading to several downgrades in its credit ratings.

As a result, the market now perceives Alpha Corp as a riskier borrower. To compensate for this increased risk, investors demand a higher yield on Alpha Corp's bonds. Although the contractual cash flows of the bonds (principal and interest payments) remain unchanged, the market's required discount rate for those cash flows has increased. This causes the fair value of Alpha Corp's outstanding bonds to fall from \$100 million to, say, \$95 million.

Under fair value accounting, Alpha Corp would recognize a \$5 million "gain" on its balance sheet from the decrease in the fair value of its own liabilities. This gain reflects the reduction in the present value of its future payment obligations, driven entirely by the market's reassessment of Alpha Corp's own credit risk, not by any operational improvement or strategic decision.

Practical Applications

Own credit risk has significant practical applications, particularly in financial reporting, risk management, and regulatory compliance.

• Fair Value Accounting: The most direct application is in financial reporting under standards like ASC 820 (Fair Value Measurement) in U.S. GAAP and IFRS 13, which mandate that entities measure certain liabilities at fair value, explicitly incorporating their own credit risk¹⁴. This ensures that the fair value reported on financial statements reflects the price at which the liability could be transferred to a market participant with a similar credit standing¹³,¹²,¹¹.
• Derivatives Valuation: In the valuation of derivative financial instruments, changes in an entity's own credit risk are incorporated through a Debit Valuation Adjustment (DVA). DVA accounts for the benefit a derivatives counterparty receives from the potential default risk of the entity itself. Regulators, such as the Basel Committee on Banking Supervision, have also addressed how changes in banks' own credit risk on derivatives should be treated for regulatory capital purposes, often requiring unrealized gains from improved creditworthiness to be derecognized from Common Equity Tier 1 capital to avoid artificially inflating capital¹⁰.
• Risk Management and Capital Allocation: While an accounting "gain" may arise, sophisticated risk management frameworks consider the true economic implications of declining credit quality. Financial institutions must manage their capital structure and overall solvency in light of potential increases in their borrowing costs and reduced investor confidence, irrespective of accounting entries.

Limitations and Criticisms

Despite its role in fair value accounting, the concept of recognizing gains or losses from changes in own credit risk has faced substantial criticism, primarily for its counterintuitive nature.

• Counterintuitive Outcomes: The most prominent criticism is the paradoxical outcome where a company reports an accounting gain when its creditworthiness deteriorates, signaling financial distress, or a loss when its creditworthiness improves, signaling financial strength⁹,⁸. This can confuse bondholders, investors, and other stakeholders who may misinterpret these accounting gains or losses as indicators of operational performance rather than changes in the market value of liabilities due to credit perceptions. Some financial professionals find it difficult to interpret a gain as a direct signal of a deterioration in financial position⁷.
• Measurement Challenges: Accurately isolating the portion of a liability's fair value change attributable solely to changes in own credit risk can be complex. Market prices for debt instruments are influenced by numerous factors, including interest rate risk, liquidity risk, and broader market sentiment, making it challenging to precisely disentangle the impact of own credit risk⁶.
• Moral Hazard Concerns: Some critics argue that recognizing a gain when a company's credit deteriorates could, theoretically, create a perverse incentive or at least obscure the true implications of declining financial health, although regulatory capital adjustments often mitigate this for financial institutions. The European Banking Authority (EBA) has noted that considering own credit risk in certain regulatory capital calculations "makes no sense" as it could lead to counterintuitive outcomes where a deterioration in an institution's economic situation results in issued liabilities hedging assets through an offsetting effect⁵.

Own Credit Risk vs. Counterparty Risk

While both own credit risk and counterparty risk fall under the broader umbrella of credit risk, they refer to distinct aspects of financial exposure.

In essence, own credit risk is unilateral, concerning the risk that you won't pay your debts, whereas counterparty risk is typically bilateral, concerning the risk that the other party to a contract won't fulfill their obligations². For example, in a credit default swap, the buyer faces counterparty risk from the seller, while the seller faces own credit risk on its outstanding debt instruments.

FAQs

Why does a decline in my company's credit rating sometimes lead to an accounting gain?

When a company's credit ratings decline, the market perceives its outstanding debt instruments as riskier. This increased risk means investors demand a higher return (or discount rate) for holding that debt. When the future contractual cash flows of the debt are discounted at this higher rate, the present value (fair value) of the liability decreases. This decrease in liability value is recognized as an accounting gain on the balance sheet, even though it reflects a worsening financial outlook.

Is own credit risk relevant for all types of liabilities?

Own credit risk is most explicitly relevant for liabilities that are measured at fair value on an entity's financial statements. For liabilities measured at amortized cost (like many traditional loans or corporate bonds held to maturity), changes in the entity's own credit risk do not directly impact the carrying value on the balance sheet, though they are implicitly reflected in the interest rate charged upon issuance and can affect refinancing options.

How do regulators view own credit risk?

Regulators, especially in the banking sector, are keenly aware of own credit risk. They generally seek to ensure that accounting treatments do not create misleading impressions of financial stability. For instance, Basel III capital rules require banks to neutralize gains arising from changes in their own credit risk when calculating Common Equity Tier 1 capital, preventing a bank from appearing stronger merely because its own debt has become cheaper due to its deteriorating health¹.

Can own credit risk be hedged?

While you cannot "hedge" your own inherent creditworthiness, entities can manage the exposure of their liabilities to fair value changes related to own credit risk. For example, a company might use derivatives to offset the market value fluctuations of its liabilities, including those driven by its own credit perceptions. However, the fundamental default risk of the entity remains.