Credit Loss Estimation Methodologies

Lourenco Miranda

THE CREDIT RISK PROBLEM

This chapter will analyse credit loss projections in a CCAR context. Credit risk is probably the most important of the exposures in the financial system. Although it is not as old as operational risk (as we will see in the next chapter), it does carry the most risk exposure to the firm. For that reason, we begin the loss projections with it. When does the credit risk start? After the loan is disbursed, in the case of a commercial bank for instance, what was initially a credit application becomes a credit exposure for the bank. The Bank will therefore start monitoring the exposure during the whole life of the loan.

This chapter will also explore how banks use a wide range of methods to estimate credit losses, depending on the type and size of portfolios and data availability. These methods can be based on either an economic loss approach (that is, expected losses, which is a function of three economic components) or an accounting-based loss approach (that is, charge-off and recovery).

A creditor charges-off a credit account when it is declaring debt as a loss for the bank, which means that the amount of debt is unlikely to be collected. Usually, credi

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