The Handbook of Credit Risk Management, 2nd Edition

CHAPTER 14Economic Capital and Credit Value at Risk (CVaR)

The question we address in this chapter is how to quantify the amount of capital necessary to support a credit portfolio. We begin by defining capital since capital itself has various meanings. We then describe credit value at risk, or CVaR, a technique widely used for quantification. We describe what it is, how to interpret it, how it's calculated, and how the risk manager can influence it. Lastly, we cover CVaR's role in the risk manager's toolbox and its limitations.

By supporting a credit portfolio, we mean to not only avoid bankrupting one's institution but keeping it in good standing with all constituents—customers, regulators, ratings agencies, and creditors. The way in which capital supports a credit portfolio is by absorbing unforeseen or unexpected losses.

A company can easily manage expected losses, and because it expects them, their occurrence can be reasonably quantified, and interest income or revenue can be collected to offset them. For these losses, capital is not required. The problem arises from unexpected losses. Losses can be bigger than expected because, for example, the number of defaults is larger than expected, high exposures are hit, recovery is less than anticipated, or a combination of all these factors. The capital absorbs these losses. Its presence is like a cushion in the unlikely event that credit losses are far greater than expected and current earnings are insufficient to cover them. ...