Learning outcomes: Evaluate a bank’s economic capital relative to its level of credit risk. Identify and describe important factors used to calculate economic capital for credit risk: probability of default, exposure, and loss rate.
505.1. According to Schroeck, economic capital is an estimate of the overall level of capital necessary to guarantee the solvencyof the bank at some predetermined confidence level. Which stakeholder tranche represents the “critical threshold” targeting by this confidence level?
a. Equity shareholders
b. Deposits and savings from insured customers
c. Senior uninsured debt
d. Junior uninsured debt
505.2. Which of the following is TRUE about expected credit loss?
a. Expected loss itself constitutes risk
b. Expected loss represents credit loss levels that do NOT fluctuate year to year
c. Expected loss is calculated from the bottom up (transaction by transaction) and reimbursed through adequate loan pricing
d. Expected loss is the risk that arises due to the variation in loss levels and therefore justifies the rationale for economic capital
505.3. Expected loss (EL) has three components: probability of default (PD), exposure amount (EA), and loss rate (LR). With respect to these components of EL, each of the following is trueEXCEPT which is not accurate?
a. Exposure amount (EA) is the standard deviation of credit losses estimated at the end of the horizon excluding outstanding interest payments
b. Probability of default (PD) is the probability that a borrower will default before the end of a predetermined period of time (the estimation horizon typically chosen is one year)
c. Loss rate (LR) represents the ratio of actual losses incurred at the time of default (including all costs associated with the collection and sale of collateral) to the exposure amount
d. Expected loss (EL) is equal to the product of: the probability of default up to time H (horizon); the exposure amount at time H; and the loss rate experienced at time H; i.e., EL(H) = PD(H)*EA(H)*LR(H)