Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 28 5.2 Basic Framework This section and Figure 14 outline the basic components for measuring credit economic capital, as follows. Figure 14: Framework for Measuring Economic Capital for Credit Risk • Distribution of portfolio credit losses - The calculation of credit economic capital is based on the distribution of portfolio credit losses over a given time horizon. The distribution is highly skewed. Generating a portfolio credit loss distribution is a nontrivial process, and the elements that go into its calculation are described in Section 5.3. • Time horizon - The time horizon over which the distribution is generated is ultimately a business decision. Note that the time horizon for calculating credit economic capital is not necessarily the same as the time horizon for calculating a credit charge. With long-term contracts, charging for credit risk needs to be calculated over the life of the deal. (See Figure 16 for an example of counterparty exposure over life of deals in comparison to one year.) • Portfolio expected loss – The portfolio expected loss is given by the mean of the distribution of losses. • Credit economic capital – Credit economic capital is viewed as unexpected credit loss and is simply the difference between the confidence level and the portfolio expected loss. The mean and variance of the portfolio credit loss distribution and the confidence level chosen by the company affect the economic capital associated with credit risk. Companies can reduce their credit economic capital by reducing the variance of their credit portfolio or by lowering their chosen confidence level. Probability Portfolio Expected Loss (Mean) Distribution of Portfolio Credit Losses Over a One-Year Time Horizon Credit Economic Capital (Unexpected Loss) Confidence Level Expected Loss (Loss Provisions)