Evaluating a Bank’s Economic Capital Relative to its Level of Credit Risk
The term credit risk describes the risk that arises from nonpayment or rescheduling of any promised payment. It can also
arise from credit migration – events related to changes in the credit quality of the borrower. These events have the
potential to cause economic loss to the bank.
The expected loss is the amount a bank can expect to lose, on average, over a predetermined period when extending
credits to its customers. Unexpected loss is the volatility of credit losses around its expected loss.
Once a bank determines its expected loss, it sets aside credit reserves in preparation. However, for unexpected loss, the
bank must estimate the excess capital reserves needed subject to a predetermined confidence level. This excess capital
needed to match the bank’s estimate of unexpected loss is known as economic capital.
To safeguard its long-term financial health, a lender must match its capital reserves with the amount of credit risk borne.
Economic capital is largely determined by (I) level of confidence, and (II) level of risk. An increase in any of these two
parameters causes the economic capital also to increase.
Important Factors Used to Calculate Economic Capital for Credit Risk
The Probability of Default
The probability of default (PD), describes the probability that a borrower will default on contractual payments before the
end of a predetermined period. This probability is in and of itself not the greatest concern to a lender because a borrower
may default but then bounce back and settle the missed payments soon afterward, including any imposed penalties. It’s
expressed as a percentage.
Exposure Amount
Exposure amount (EA), also known as exposure at default (EAD), is the loss exposure of a bank at the time of a loan’s
default, expressed as a dollar amount. It’s the predicted amount of loss in the event the borrower defaults.
EAD is a dynamic amount that keeps on changing as the borrower continues to make payments.
Loss Rate
The loss rate, also known as the loss given default (LGD), is the percentage loss incurred if the borrower defaults. It can
also be described as the expected loss expressed as a percentage. The loss rate is the amount that’s impossible to recover
after selling (salvaging) the underlying asset following a default event.
The LGD can also be expressed as:
LGD=1–RecoveryRate
Calculation of the Expected Loss
The expected loss, ELEL, is the average credit loss that we would expect from an exposure or a portfolio over a given
period. It’s the anticipated deterioration in the value of a risky asset. In mathematical terms,
EL=EA×PD×LGD
Credit loss levels are not constant but rather fluctuate from year to year. The expected loss represents the anticipated
average loss that can be statistically determined. The business will normally have a budget for the ELEL and try to bear
the losses as part of the normal operating cash flows.
Exam tip: The expected loss of a portfolio is equal to the summation of expected losses of individual losses.
ELP=∑EAi×PDi×LGDi
Unexpected Loss
Unexpected loss is the average total loss over and above the expected loss. It’s the variation in the expected loss.
You will usually apply the following formula to determine the value of the unexpected loss:
UL=EA×√ PD×σ2LR+LR2×σ2PD
Example: Expected loss and unexpected loss
A Canadian bank recently disbursed a CAD 2 million loan of which CAD 1.6 million is currently outstanding. According to
the bank’s internal rating model, the beneficiary has a 1% chance of defaulting over the next year. In case that happens,
the estimated loss rate is 30%. The probability of default and the loss rate have standard deviations of 6% and 20%,
respectively.
Determine the expected and unexpected loss figures for the bank.
Calculating the Unexpected Loss of A Portfolio
Unlike expected loss, we do not compute the unexpected loss of a portfolio by summing up the unexpected loss of
individual assets. And this is because the standard deviation of the sum will not be the same as the sum of standard
deviation unless there is a perfect correlation.
For a two-asset portfolio:
ULP=√ UL2i+UL2j+2ρULiULj
Due to the effects of diversification (elimination of specific risks), the risk of a portfolio is always less than the total risk
of assets held separately. It follows that the unexpected loss for a portfolio is much less than the sum of unexpected
individual losses.
The risk of a given portfolio is considerably less than the sum of the individual risk levels because each asset contributes
only a portion of its unexpected loss in the portfolio. This effect is captured by the partial derivative of UL p (portfolio
unexpected loss) with respect to ULi (unexpected loss from asset i), i.e.,
Example: unexpected loss contribution
Prime Bank has two outstanding loans with a correlation of 0.4. Other characteristics are as shown below:
Asset X Asset Y
EA $30,000,000 $12,000,000
PD 0.5% 1.0%
LR 40% 30%
σPD 3% 4%
σLR 20% 30%
Compute ELP, ULP, and the risk contribution of each asset.
Practice Questions
Q1) Big Data Inc., a U.S. based cloud technology and computing firm, has been offered a USD 10 million term loan fully
repayable in exactly two years. The bank behind the offer estimates that it will be able to recover 65% of its exposure if
the borrower defaults, and the probability of that happening is 0.8%. The bank’s expected loss one year from today
is closest to:
A. USD 52,000 B. USD 26,000 C. USD 14,000 D. USD 28,000
Q2) A bank has two assets outstanding, denominated in U.S. dollars. The correlation between the two assets is 0.4. Other
details are as follows:
Asset A Asset B
EA 1,600,000 2,000,000
PD 1% 2%
LR 30% 40%
σPD 6% 8%
σLR 20% 25%
Calculate the unexpected loss of the portfolio as well as the risk contribution of each asset:
Unexpected loss Risk Cont. A Risk Cont. B
A. 118,350 18,350 100,000
B. 125,800 102,600 23,200
C. 120,000 98,000 22,000
D. 119,308 29,302 90,006
Q3) Consider a corporate bond. Per 100 of par value, its exposure is 96, and recovery is 50. The probability of default
(POD) is 0.5%. What is the expected loss due to credit risk?
A. 0.15
B. 0.21
C. 0.23
