Managing Credit Risk
Previous chapters have explained how to estimate the various input to portfolio credit risk models, including default probabilities, credit exposures, and recovery rates for individual credits. We now turn to the measurement of credit risk for the overall portfolio.
In the past, credit risk was measured on a stand-alone basis, in terms of a “yes” or “no” decision by a credit officer. Some consideration was given to portfolio effects through very crude concentration limits at the overall level. Portfolio theory, however, teaches us that risk should be viewed in the context of the contribution to the total risk of a portfolio, not in isolation. Indeed, the new credit risk models measure risk on a portfolio basis.
While this focus on diversification also exists in market risk management, credit risk is markedly more complex. In particular, it is difficult to estimate probabilities and correlations of default events. These correlations, however, are essential drivers of diversification benefits, as we have seen in Chapter 19.
Section 24.1 introduces the distribution of credit losses. This has two major features. The first is the expected credit loss, which is essential information for pricing and reserving purposes, as explained in Section 24.2. The second component is the unexpected credit loss, or worst deviation from the expected loss at some confidence level. Section 24.3 shows how this credit value at risk (credit VAR), like market VAR, can be ...