4. CREDIT RISK
4.1. DEFINITION AND CAUSES
Credit risk or default risk is the risk of default on receivables resulting from the failure of counterparties to meet their contractual obligations. Country risk is the element of credit risk relating to the risk of default by a borrower abroad resulting from interruptions to the international payment transfer system in the borrower’s country of residence (transfer risk). In addition, country risk refers to the risk that governments are unable or only partially able to meet their contractual obligations.
Credit risk may arise in traditional lending business and also in trading activities. Traditional lending business is for the most part commercial lending, including financial guarantee contracts and loan commitments. In the context of credit risk management, trading activities refers to securities business – comprising securities in both the banking book and the trading book including promissory notes, derivatives, and the assets underlying derivatives – and secured and unsecured money market business (including sale and repurchase agreements, referred to below as ‘repo’ transactions).
Credit risk in connection with trading activities arises in the form of replacement risk, settlement risk, and issuer risk. Replacement risk on derivatives is the risk of counterparty default before the settlement date of a trading transaction with a positive fair value. A financial loss arises from the need to replace the transaction at the prevailing market terms. Money market business (for example, repo transactions) also generates replacement risk.
Settlement risk arises in connection with trading transactions that are not processed concurrently. The risk is that counterparties do not meet their obligations, counter-performance already having taken place.
Issuer risk is the risk that the issuer of a security does not meet its contractual obligations. In this case, the holder of the security incurs a financial loss in the form of interest and principal payments not received. There are also issuer risks attached to derivative contracts (for example, credit derivatives), where the default of the underlying asset can lead to losses.
Credit risk from traditional lending business arises primarily at DZ BANK, BSH, DG HYP, DVB, TeamBank, and VR-LEASING. The risk results from the specific transactions in each company and therefore has varying characteristics in terms of diversification and size in relation to the volume of business.
Credit risk from trading activities arises particularly at DZ BANK, BSH, DG HYP, and DZ PRIVATBANK. Replacement risk and settlement risk arise largely in connection with DZ BANK’s trading activities. Issuer risk results mainly from the trading activities and investment business conducted by DZ BANK, BSH, DG HYP, and DZ PRIVATBANK. BSH, DG HYP and DZ PRIVATBANK only incur credit risk on banking book trading activities. BSH restricts its investments mainly to investment-grade securities.