Uncertainty, Credit Migration, Stressed Scenarios and Portfolio Losses

Jorge Sobehart


The approach to measuring risk and managing capital has evolved at an accelerated pace over the past decade. This accelerated pace of change reflects the shift from identifying and studying methodologies for loss provisioning, capital measurement and allocation to actually creating the necessary infrastructure and implementing these methodologies. New regulatory guidance on capital adequacy (Basel Committee on Banking Supervision 2004, 2005a,b; Jones and Mingo 1998; and Nuxoll 1999) provides strong incentive for financial institutions to use internal risk management systems to measure risk and determine sufficient regulatory and economic risk capital. While commercial risk measurement tools can be used as components of an overall solution, most institutions recognise that such systems must be tailored to their own portfolios and that some of the development and implementation work will fall to their own risk management teams.

Broadly, risk capital can be defined as a cushion to absorb unexpected losses in a portfolio at a very high confidence level. Technically it is defined as the portfolio loss at a given confidence

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