What is credit risk?

Measurement combines borrower-level estimates and portfolio analytics. Probability of default (PD) is the chance a borrower defaults within a set horizon, usually one year. Loss given default (LGD) is the share of the exposure you expect to lose after recoveries and enforcement. Exposure at default (EAD) is the amount outstanding at default, including undrawn facilities. For a $100,000 SME loan with a PD of 3% and an LGD of 40%, expected loss is 0.03 × 0.40 × $100,000 = $1,200.

Lenders arrive at PD through credit scoring models (scorecards, logistic regression, decision trees) that map income and repayment history to a default probability, through external ratings for larger issuers, and through migration matrices that track how ratings move over time. At portfolio level they use credit value-at-risk, concentration indices and factor models to capture correlation between borrowers, and increasingly machine learning, with governance and explainability as the constraints.

Controls are layered. Underwriting screens the borrower with affordability checks, industry analysis and stress tests of cash flow. Collateral such as mortgages, fixed and floating charges and pledged receivables improves recovery, provided the asset is good quality and the security is enforceable, which for equipment means timely PPSR registration and, if needed, repossession. Covenants (debt service cover, leverage limits, negative undertakings) give the lender early rights to act as a borrower's position deteriorates, and guarantees from directors or parent companies add another source of repayment.

Beyond the individual loan, lenders cap exposure by sector, borrower and product, net exposures across contracts, occasionally transfer risk through credit derivatives, and run early-warning systems: payment monitoring, watchlists, covenant triggers and automated alerts.

Credit risk is a core input to pricing. Lenders add a credit spread above their funding or benchmark rate to cover expected loss, the cost of capital and operating costs, and a higher PD or LGD typically brings a shorter term, a higher margin, tighter covenants or a requirement for collateral. Because prudential rules make riskier exposures attract more capital, the lender's required return, and therefore your price, rises with the risk.

A small business can lower the credit risk a lender sees by keeping its financials timely, reducing undrawn commitments, offering collateral, agreeing realistic covenants, and using invoice discounting or asset finance rather than unsecured borrowing. APRA sets prudential expectations for capital and model governance, ASIC enforces credit licensing and responsible lending, the RBA watches credit cycles for stability, and AASB 9 governs provisioning.