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Case Study

Economic Capital Models for Credit Risk Measurement

FOCUS ON: Case studies,

SUMMARY

Avantage Reply assisted a retail bank in review of current models used for the measurement of economic capital needs to cover the risks in credit portfolio. The current models being based on the Risk-Adjusted Capital Framework Methodology, the goal was to assess whether other methodologies would be better suited, what constraints would apply to alternative methods and how to integrate concentration risks and credit pricing into the model. The solution needed to be not only in line with best market practices but also consider the client’s limited availability of usable data for the calculation of the risk exposures. Avantage Reply provided the client with training on the different models that might be used, their advantages and disadvantages, as well as some guidance on how these models could be used in the pricing and implemented in the existing IT set-up.

CUSTOMER GOALS

The client, a retail bank, wanted to review their risk models for the measurement of economic capital needed to cover the credit risks in their portfolio. Particular focus would need to be placed on the measurement of concentration risks, the use of economic capital models in risk-adjusted credit pricing and the technical solutions for an effective implementation.

CHALLENGES

As part of the internal capital adequacy assessment, banks need to quantify the main sources of risk and ensure they hold a sufficient amount of capital above the required regulatory capital to cover these internally assessed risks. The project was to evaluate the currently used methodology and propose an additional metric to cover the bank’s exposure to concentration risks that would complement the credit risk quantification methodology.

The main problems for the client were a limited availability of historical data that would allow for more sophisticated methodologies and an excessive reliance on modified Pillar I calculation methods with incoherent assumptions used for their internal capital modeling.

SOLUTION

Avantage Reply gave the client a dedicated training on the different commonly used methodologies to quantify economic credit risks and concentration risks, as well as best practices in the market. Additionally, the team reviewed the currently used methodology both with regards to internal own funds calculation and credit risk exposure calculation and provided detailed recommendations for different alternative methods for calculation, their respective advantages and limitations. Avantage Reply also proposed different metrics that might be used to estimate concentration risks in the credit portfolio of the client and how these estimates might be used in the credit pricing process. Lastly, a subject matter expert provided a detailed recommendation for the tools and production processes that might be used to implement these changes.

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