Fundamentals of credit - lecture #2

Published on April 27, 2016   24 min

Other Talks in the Category: Finance, Accounting & Economics

Hello, my name is Marwa Hammam. I'm the Executive Director of the Master of Finance Program at Cambridge University. In today's talk, I'm going to be carrying on form the discussion that we started around the credit equation, looking at probability of default, loss given default more closely, and then, looking at linkages between credit and market risk, which are fundamentally important as established by the requirements under Basel II and three and beyond.
So going back to our discussion last time on excepted credit loss and the components that drive them, and we've established those are largely at the probability of default, and a very good proxy for which is the risk creating of the counterparty. Loss given default, which is defined as one minus the recovery rate. There are preset parameters, as I mentioned in the previous talk, whereby the Basel court required a 45 percent loss given default charge in the event of collateralized exposure. And 75 percent loss given default for subordinated exposures.
In the world of credit, outcomes are fairly binary, i.e., there is either a default or no default. In the event of non-default, the credit loss is zero and the probability of that scenario unfolding is 1 - PD. In the event of a default, the loss amount is quantified by looking at the loss given default, multiplied by the exposure at default, which is generally the amount of exposure on the books at the point of default. And the probability of that scenario is PD. As you could see on the equation at the bottom of this slide, it's very rare that banks have a single instrument or single exposure to one client. Often, they have multiple exposures and the expected loss for a client is calculated by looking at the probability of default and loss given default for each piece of exposure. And that is rolled up into what is the expected loss for that client overall, or for a portfolio of credits if that same equation is applied across multiple exposures and multiple counterparties.