Volume 4— Credit Risk Management © Copyright 2002, CCRO. All rights reserved. 16 Credit Charges Ideally, risk originating units should be assessed a credit charge that reflects the cost of managing the credit risk of the transaction or portfolio. (See discussion on Cost of Credit in Section III.) If a market-based cost of credit is not available, the credit charge could be set based on the expected loss and the CVaR. Credit Reserves If the cost of credit is not already captured in the MTM process, credit reserves should be taken to reflect the impact of credit risk on the fair value of the position. Ideally, the reserves should reflect the cost of laying off the credit risk to the market. When market indications for this purpose are not available, credit reserves can be set based on the current and potential credit exposure, taking into account netting arrangements, collateral, and estimated default experience based on the credit ratings of counterparties. Credit Capital To address the risk that losses could significantly exceed the expected loss in case of default, the company must allocate enough credit capital to absorb unexpected portfolio credit losses at some high confidence level (the confidence level used could be set as a function of the credit rating that the company wishes to maintain). A significant area of future work for the CCRO will be to describe a framework that can help industry participants address capital adequacy issues. 5.0 Stress Testing and Scenario Analysis 1 A thorough program for measuring credit risk should include stress testing to measure the impact that extreme events or combinations of events would be expected to have if they occurred. The factors to be stressed are market factors, counterparty factors, and the correlations among market factors and counterparties. The risk manager should identify (1) extreme market events that give rise to extreme credit exposures for the portfolio as a whole, (2) individual counterparties where a large exposure may become a large risk in the event of adverse developments for that counterparty, and (3) combinations of events that, although currently uncorrelated, could become correlated and thereby create large risks. While these extreme scenarios may have a very small probability of occurrence, the intent of stress testing is to identify their impact if they do occur and confirm the survivability of the company in the event of such rare occurrences. More important, tracking the stress sensitivity to specific troubled individual counterparties as described in (2) provides valuable guidance on strategies to mitigate exposure. 1 See the Valuation and Risk Metrics White Paper Section III on Sensitivity Analysis, Scenario Analysis, and Stress Testing.