TABLE OF CONTENTS Credit risk is the single most important risk for a large number of financial institutions. The aim of this chapter is to define credit risk and to analyze how a bank might classify its borrowers, evaluate the expected and unexpected losses that may derive from its credit portfolio, and calculate credit risk VaR. In Section 4.1 we present the difference between expected and unexpected losses. We show that the former are on average unavoidable (hence, they should be treated as a cost of being in the lending business and covered by adequate provisions), while unexpected losses are associated with unfavorable scenarios and should be covered by shareholder capital. In the following sections we will see how those two components can be estimated and managed.
A credit risk management system can consider different sources of losses, depending on the valuation methodology used, which can be based either on a mark-to-market (MTM) approach or on a book-value accounting (BVA) approach. In the MTM approach, the value of a credit risk sensitive position is the value at which it could be traded on the market if a market for it were available. [1.] In principle, this should equate the present value of future cash flows discounted at a rate depending on the riskiness of the exposure. Accordingly, any decrease in this present value due, e.g., to an increase in the risk-adjusted discount rate, will represent a credit loss. Hence, a downgrade of the borrower, leading...
