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# Loan Equivalent Approach

#### ckyeh

##### New Member
Dear David:

Operational and Integrated Risk Management
AIMSCrouchy, Risk Management, Chapter 14 Capital Allocation and Performance Measurement

Descrbe the Loan Equivalent Approach and use it to calculate RAROC capital.

First, I couldn't understand what Table 14.3 Loan Equivalent Factors try to convey.
For example, what does RR 1-9 and RR 10-12 represent?

Many Thanks!!!

#### David Harper CFA FRM

##### David Harper CFA FRM
Staff member
Subscriber
Hi ckyeh,

Chapter 7 of Crouhy is devoted to risk ratings (RR) but the table 7.3 is merely an illustrative "prototype." They are the internal analogs to external credit ratings (e.g., S&P BBB, Moody's Baa). A bank will typically map the PDs (which are unrealistically continuous and cardinal) to the less granular risk ratings. Since Basel II is ratings-based, typically, a bank will have an well-developed process for mapping PD to risk ratings; this book is basically devoted to the process

The intent is that each risk rating contains a "homogenous" group containing obligors with similar PD and LGD.

From Crouhy (pages 270-271): "A typical risk rating methodology (RRM) initially assigns an obligor rating that identifies the expected probability of default by that borrower (or group) in repaying its obligations in the normal course of business. The risk rating system (RRS) then identifies the risk of loss (principal or interest) by assigning an RR to each individual credit facility granted to an obligor. Risk ratings quantify the quality of individual facilities, credits, and portfolios. If RRs are accurately and consistently applied, then they provide a common understanding of risk levels and allow for active portfolio management. An RRS also provides the initial basis for capital charges used in various pricing models. It can also assist in establishing loan reserves. The RRS can be used to rate credit risks in most of the major corporate and commercial sectors, but it is unlikely to cover all business sectors."

The other thing i'd add is a conceptual link to (FRM assigned) Ong where he applies a UGD to the undrawn commitment; and he calls that "optionality." It is superficially the same thing: if there is an undrawn committment of, say, $10 MM and but highly rated (e.g., RR 2 or 3 or 4; high quality, low PD) then maybe multiply by only 50%; but if low rated (e..g, RR 11 or 12; low quality, high PD) maybe multiply by full 100%. I compare because, in both cases, you are taking a$100 MM facility and the problem is that you may/probability don't want to count the entire amount as exposure (or adjusted exposure). It's cash that hasn't left the vault!. Where Ong multiplies by UGD to convert to adjusted exposure, this system is multiplying a higher-rated credit by (eg.) 50% to get a loan-equivalent. But there is nothing magic about the numbers shown, just illustrative...

Hope that helps, David

#### NNath

##### Active Member
Hi David, I went through first page of the Crouhy text on this. I got all 3 questions wrong on the loan equivalent approach from the QS. I also could not find the excel sheet with table 14.3. but that's ok since i found the table in the actual textbook, however it did not have the details that you put together. I guess if there is no calculation required for this LO (Describe) could you please list the key point to remember for the exam. That will be a great help. Thanks.