Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

11.10 Conclusion

As I said early on, this chapter does not take a standard approach to discussing credit risk. I have focused heavily on the mathematics and the modeling required to build the P&L distribution, much less on the traditional techniques of credit measurement and management. I think this approach is justified on two grounds. First, the modeling required to build the P&L distribution for nontraded credit risks is simple in concept but difficult in practice. I have tried to lay out the conceptual framework and highlight the simplicity of the concepts while also stressing the difficulties and subtleties of building and implementing a practical credit risk system. Second, there are many texts that do a good job of discussing the more traditional approaches to credit risk. Readers can remedy any omissions without undue difficulty.

I do want to highlight, however, the wide range of credit risk topics not covered.

In general, credit risk management is composed of three components:

1. Measurement.

2. Setting reserves, provisions, and economic capital.

3. Other management areas: setting limits, portfolio management, managing people and incentives.

The primary focus of this chapter has been on determining the distribution for defaults, which is only the first component of measuring credit risk. Measurement means determining the profit and loss (P&L) distribution. The loss itself depends on default, exposure, and recovery:

Defaults have taken center stage because default modeling ...