This lesson examines the quantitative tools used to measure credit risk, including the estimation of Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD).

6.1 The Components of Expected Loss
Expected loss (EL) is a key metric in credit risk management, calculated as the product of three components :

  • Probability of Default (PD): The likelihood that a borrower will default on its obligations within a given time horizon.

  • Loss Given Default (LGD): The percentage of the exposure that will be lost if the borrower defaults, after accounting for recoveries from collateral and other sources.

  • Exposure at Default (EAD): The total value of the exposure outstanding at the time of default.

6.2 Quantitative and Qualitative Risk Assessment
Credit risk measurement combines quantitative and qualitative approaches . Quantitative methods include:

  • Scoring Models: Statistical models (e.g., credit scoring systems) that assign a score to a borrower based on financial and non-financial characteristics .

  • Credit Ratings: Internal and external ratings that assess creditworthiness.

  • Portfolio Models: Models that measure the risk of a portfolio of exposures, including correlation and diversification effects .

6.3 Credit Value at Risk (Credit VaR)
Credit VaR is a measure of the potential loss in the value of a credit portfolio due to default and credit migration over a given time horizon at a specified confidence level . It is calculated using:

  • Credit Migration Models: Measuring the likelihood and impact of rating changes.

  • Default Models: Measuring the likelihood and impact of default.

  • Correlation Models: Measuring the interdependence of defaults across exposures .

6.4 The Role of Risk Grading
Risk grading systems are used to classify borrowers by risk level, facilitating portfolio monitoring and regulatory reporting . Key elements include:

  • Internal Risk Ratings: Customised ratings based on the institution’s own assessment.

  • External Credit Ratings: Ratings from agencies such as S&P, Moody’s, and Fitch.

  • Watchlist Management: Monitoring borrowers showing signs of deterioration.

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