Financial Risk Management: Applications in Market, Credit, Asset and Liability Management and Firmwide Risk

Chapter 4Portfolio Credit Risk

For many financial institutions the credit risk in the banking and trading book represents by far the largest financial risk exposure. The 2007 financial crisis is of course a prominent example of the importance of managing credit risk and as a result of the experiences in the 2007 financial crisis regulators have been very active in developing new, stricter regulations for credit risk under the heading of Basel III. Many of the new regulations were driven by reports on the (failed) risk management practices during the crisis. See, for example, the Senior Supervisors Group (2008) and Financial Stability Forum (2008) reports.

As we have discussed in the introduction to this book credit risk capital requirements have a long history. The larger banks use the advanced internal ratings based approach originating from Basel II to calculate risk weighted assets for credit risk. The advanced Basel charge for credit risk is model based, though the model is prescribed by regulators, and require banks to estimate model input parameters such as the probability of default, loss given default and exposure at default for the credit exposures. In 2009, with Basel 2.5, banks were also allowed to develop fully internal model based charges for bond trading exposures termed the incremental risk charge. The incremental risk charge assigns liquidity trading horizons to the bonds and uses the banks own bond portfolio credit risk model. Credit risk is also a main part ...