Risk Management

Credit Risk
Credit Risk

• Can we get an estimate of potential losses?

• How much capital should we hold against potential losses?

• Economic capital: What they would have hold without regulation.

• Regulatory capital.

• Banks use various measures and models such as Value-at-Risk

(VaR) models and Expected Shortfall (ES) to calculate
economic/regulatory capital.
VaR
• Widely used risk measure for losses on a portfolio of assets.

• Commonly used for:

• Risk management
• Financial control
• Financial Reporting
• Computing regulatory capital
VaR
• Components:
• Portfolio of assets
• Time horizon
• Probability denoted by p.

• 100p% VaR is the threshold loss value such that:

• Probability that the loss on the portfolio over the given time
horizon exceeds this value is p.
VaR
• 100p% VaR is the threshold loss value such that:
• Probability that the loss on the portfolio over the given time
horizon exceeds this value is p.

• Example: p=0.01. Time horizon is 1 week.

• 1% VaR of €10 million means:

• There is a 0.01 probability that the losses on the portfolio will
exceed €10 million over a week.
VaR: Economic and Regulatory Capital

Assets Liabilities
Risky assets: R0 Debt (d)
Equity(e)

• Suppose the risky portfolio costs R0 at t=0.

• Financed with debt (d) and equity (e), where d+e=R0.

• Suppose (approximation) the return R1 from the risky investment

at t=1 has a Normal distribution with mean µ1 and std σ, N(µ1,σ).
VaR: Economic and Regulatory Capital

Assets Liabilities
Risky assets: R0 Debt (d)
Equity(e)

• Bank wants to keep the probability of default at most at 2.5%. Find

economic capital.

• Regulator wants to keep the probability of default at most at 0.5%.

Find regulatory capital.

• Economic/regulatory capital increases with µ1: TRUE/FALSE

• Economic/regulatory capital increases with σ: TRUE/FALSE
VaR: Economic Capital
• The return at t=1 is R1.

• The bank defaults if R1 < d.

• The bank wants this probability to be 2.5%: Pr(R1 < d) = 0.025.

• This corresponds to the 2.5% lower tail of the Normal distribution.

• At the 2.5% tail of the Normal distribution R1 = µ1 – 1,96σ.

• The bank defaults with a probability of 2.5% when R1 = µ1 – 1,96σ.

VaR: Economic Capital
• The bank defaults if R1 < d.

• This corresponds to d < µ1 – 1,96σ.

• We have d+e=R0, that is, d=R0-e.

• d < µ1 – 1,96σ

• R0 – e < µ1 – 1,96σ

• Economic capital is given as: e ≥ R0 – µ1 + 1,96σ.

VaR: Economic Capital

• Suppose R0=100, µ1=105 and σ=5.

• Economic capital = R0 – µ1 + 1,96σ = 100 – 105 + 1,96x5 = 4,8.

VaR: Regulatory Capital
• Regulator keeps the probability of default at most at 0.5%.

• The bank defaults if R1 < d.

• At the 0.5% tail of the Normal distribution R1 = µ1 – 2,57σ.

• The bank defaults with a probability of 0.5% when R1 = µ1 – 2,57σ.

• This corresponds to d < µ1 – 2,57σ.

VaR: Regulatory Capital
• The bank defaults if R1 < d.

• This corresponds to d < µ1 – 2,57σ.

• We have d+e=R0, that is, d=R0-e.

• d < µ1 – 2,57σ

• R0 – e < µ1 – 2,57σ

• Economic capital is given as: e ≥ R0 – µ1 + 2,57σ.

VaR: Regulatory Capital

• Suppose R0=100, µ1=105 and σ=5.

• Economic capital = R0 – µ1 + 1,96σ = 100 – 105 + 1,96x5 = 4,8.

• Regulatory capital = R0 – µ1 + 2,57σ = 100 – 105 + 2,57x5 = 7,85.

Expected Shortfall
• One of the shortcomings of VaR is that it gives the minimum loss
for a given probability.

• However, losses can be much larger in the tail.

• VaR can miss tail risk.

• Expected shortfall tries to address this shortcoming.

• Also called conditional VaR (CVaR), average VaR (AVaR) and

expected tail loss (ETL).
Expected Shortfall