Credit risk measurement and management
Credit risk measurement and management
This domain tests how lenders quantify default and recovery, price expected loss, hold capital for unexpected loss, and use mitigation and credit derivatives. Expect calculations of expected loss and questions on ratings, the Merton model, collateral, netting and Basel approaches.
Core rules and concepts
- Credit risk components: probability of default (PD), loss given default (LGD) and exposure at default (EAD). Expected loss = PD x LGD x EAD. Unexpected loss is covered by economic capital and regulatory capital.
- LGD is one minus recovery rate, adjusted for workout costs and time to recovery; it is not simply one minus PD.
- The 5 Cs of credit: character, capacity, capital, collateral and conditions. Internal ratings and scorecards combine quantitative and qualitative factors.
- The Merton structural model treats equity as a call option on firm assets; default occurs when asset value falls below debt. It links PD to leverage and asset volatility.
- Credit risk mitigation includes collateral, guarantees, credit derivatives and netting. Eligibility, legal enforceability, haircuts, maturity mismatch and wrong-way risk determine how much mitigation is recognised.
- Basel approaches range from standardised to foundation and advanced internal ratings-based approaches; CVA capital charges capture counterparty credit risk on derivatives.
Worked example
A bank has EAD of $20 million, PD of 1.5% and LGD of 45%. Expected loss is $20m x 0.015 x 0.45 = $135,000. If eligible collateral reduces LGD to 25%, expected loss falls to $20m x 0.015 x 0.25 = $75,000. The reasoning matters: PD is unchanged because collateral affects recovery, not the borrower's likelihood of default. If the collateral is illiquid or legally uncertain, the supervisor may apply a higher effective LGD, so the capital benefit is smaller than the simple arithmetic suggests.
Traps that cost marks
- Treating PD as a default rate that already includes recovery; PD and LGD are separate drivers.
- Applying mitigation without checking eligibility, haircuts, currency mismatch and maturity mismatch.
- Confusing expected loss with regulatory capital; expected loss is a pricing and provisioning concept, capital covers unexpected loss.
- Ignoring wrong-way risk, where exposure rises as the counterparty's credit quality falls.
- Assuming credit ratings are stable; migration and concentration risk can change portfolio loss distributions quickly.