So what are the potential outcomes if a bank issues a loan? The best case scenario is that a bank receives all the money that is owed to them. In this example of 100 million, 5% loan with three years to maturity, the best case outcome is that the 5 million in interest is paid each year for three years and the entire principal of 100 million is returned at the end of the three-year period. This is to say the best case outcome or upside is capped at the outset of the life of a fixed rate loan. But what happens on the downside to the bank if the borrower defaults? The worst case outcome is that they could potentially fail to recoup 100% of the amount lent to their client, meaning the downside is all of their original investment. Banks usually don't earn a great deal on an individual loan being capped at the interest they charge. If a client defaulted on a 100 million loan before they repaid any principal and similar loans earned 5% interest, it'd actually take another 20 loans of the same size just to recoup the 100 million principal. In other words, with only a 5% a year upside, you must ensure your loan losses are below 5% in a portfolio of similar loans to remain profitable. Credit risk is all about minimizing the downside risk. Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan, which is also referred to a default risk or it could be a counterparty's failure to meet their contractual obligations in a financial market activity, such as derivatives trading and this is usually called counterparty risk. Credit risk is quantified by three factors. Firstly, exposure at default or EAD is a potential dollar amount a bank could lose should the customer or counterparty default and not pay the bank what's owed to them at a given time. The next element is loss given default or LGD. If a customer or counterparty of the bank does default on their obligations to the bank, the bank will not necessarily lose all the money they're owed. The bank might hold some form of security or collateral. You might know this if you have a mortgage where the house is collateral or the bank might recover some of the money owed through bankruptcy proceedings if the borrowers are insolvent. Loss given default is expressed as a percentage ranging from 100%, meaning they'll recover nothing through insolvency proceedings down to 0% if the bank is expected to fully recover all the money that is owed to them. The final element, fail to fulfill their obligations. This is referred to as the probability of default or PD. If all these elements are multiplied together, they'll give the probability weighted loss. This is a quantification of the credit risk faced by a bank for a particular transaction or group of transactions.