Credit Risk Management
Core metrics
Expected loss EL = PD × LGD × EAD. Unexpected loss is the volatility around EL and is covered by capital; EL is covered by pricing and provisions. EAD must include undrawn commitments via credit conversion factors. LGD should be a downturn estimate reflecting collateral, seniority and workout costs. PD may be point-in-time or through-the-cycle depending on use.
Management levers
Rating and scoring models, the five Cs (character, capacity, capital, collateral, conditions), single-name and sector or geographic concentration limits, covenants, collateral, guarantees and credit derivatives, and active portfolio management through selling, hedging or securitisation. Under IFRS 9, expected credit losses are staged: Stage 1 twelve-month ECL, Stage 2 lifetime ECL after a significant increase in credit risk, Stage 3 lifetime ECL on credit-impaired assets.
Traps
- Confusing expected loss with unexpected loss or with regulatory capital.
- Ignoring wrong-way risk - exposure rising as counterparty quality falls (positive PD–EAD correlation).
- Using benign LGD or omitting workout costs.
- Forgetting undrawn lines in EAD.
- Treating a collateral haircut as eliminating risk rather than mitigating it.
- Assuming a rating migration has no P&L effect until default.
Worked example: PD 2%, LGD 45%, EAD $1,000,000 → EL = 0.02 × 0.45 × 1,000,000 = $9,000. If the facility is 60% drawn with a 1.0 CCF on the remaining commitment, EAD stays at the full $1m. With a 0.5 CCF, EAD = $600,000 + $200,000 = $800,000 and EL = $7,200.