Multi-year dynamics for forecasting economic and regulatory capital in banking

Daniel Rösch, Harald Scheule

Abstract

ABSTRACT

The determination of future credit loss distributions constitutes a fundamental challenge in many credit risk applications such as the calculation of economic and regulatory capital as well as the pricing of loans, portfolios or derivatives thereof. Currently, best practice is to assume a one-year risk horizon for the derivation of the credit loss distribution. However, the maturities of most credit risky products exceed one year and the credit loss of the whole product life has to be taken into account. This article investigates the impact of multi-year forecasts of credit risk parameters such as probabilities of default and correlations on the distribution of future losses to a credit portfolio. Moreover, the implications are demonstrated for collateralized debt obligations.