Default risk can be defined as the risk that the counterparty to a transaction does not honor its obligation.
Default could be both in terms on monetary and non-monetary terms, and it’s a part of every transaction.
For a bank or any other financial institution, the default risk refers to the risk of default on payment obligations, such as loans, and other financial transactions.
While referring to payments default on loans and bonds, the default risk is called credit risk. This means that the counterparty does not make the payment when it is due.
Payment default could occur because of various reasons:
- The counterparty may refuse to accept the payment claim – repudiation
- The counterparty may stop issuing all payments for a period of time – Moratorium. This generally happend in case of countries.
- The counterparty may default on its loan obligation – credit default.
Insolvency: Insolvency is the situation where the counterparty is unable to pay.
Bankruptcy: Bankruptcy refers to the situation where the counterparty has filed for bankruptcy to ensure fair treatment for all creditors.