A method/ technique whereby an entity can lower the credit risk of securities that are created and issued on a pool of assets, before being sold to investors. For a business entity, credit enhancement aims to improve credit risk of an entity, usually to establish more favorable terms for borrowing from the market.

As a risk-reduction technique, credit enhancement provides a form of financial support/ cushion to cover credit losses under stressed situations, particularly in the case of securities backed by a pool of collateral (such as mortgage loans or credit card receivables) to absorb and offset default losses arising on the underlying loans/ credit. Credit enhancement can be used in multiple contexts, including structured finance, project financing, public-private partnership transactions, as a risk mitigation technique/ strategy. There are different types of credit enhancement, the most common of which are: overcollateralization, excess spread, reserve account, and subordination.

Credit enhancement is considered a key component/ input that rating agencies consider when reviewing and assigning credit quality grades to securities, issued or to be issued to the market.