June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 47 of 92 5. CREDIT RISK 5.1. Introduction In determining adequate capital for credit risk, one should take a complete view of the credit portfolio and incorporate all credit risk mitigation aspects that are in place, so that an optimal level of capital is deployed commensurate with the credit risk. In addition, companies need to demonstrate to the rating agencies and other external constituents that they have in place a strong credit risk management program along with a very sound credit risk measurement and mitigation methodology. This is particularly imperative in the face of S&P’s proposed PIM approach. The inability to demonstrate a sound credit risk management framework can result in rating agencies looking unfavorably on the credit quality of the evaluated company. An inappropriate risk measurement methodology could also result in credit reserve levels that are not commensurate with the actual risk, tying up capital that could otherwise create shareholder value or leaving the company open to detrimental events. In order to determine if one is adequately capitalized for credit risk events, it is prudent to build the credit loss distribution to assess the economic capital necessary at various confidence intervals. Expected Losses (EL) should already be priced into the products a company sells, or covered though normal collateral or margining requirements, and be included as a cost of doing business. The Unexpected Losses (UL) are those that will decrease the equity that a company possesses and are associated with the credit risk portion of a company’s overall risk capital requirements. Figure 5.1 illustrates the credit loss distribution used in determining the risk capital requirements resulting for a company’s credit risk exposures. Figure 5.1 – Credit Loss Distribution 0.000 0.050 0.100 0.150 0.200 0.250 0.300 0 -1 -2 -3 -4 -5 -6 -7 -8 -9 -10 -11 Loss f r om Cr edit Def ault s ( $M M ) EL = $2.75 MM UL @ X% CI Economic Capital