Post by Reitgruber on Nov 26, 2012 9:17:46 GMT 4
The Calculus of Expected Loss: Backtesting Expected Loss with Actual Impact of Risk in a Basel II Framework
Wolfgang Reitgruber123
Abstract
The dependency structure of credit risk parameters is a key driver for capital consumption and receives regulatory and scientific attention. The impact of parameter imperfections on the quality of expected loss (EL) in the sense of a fair, unbiased estimate of risk expenses however is barely covered. So far there are no established backtesting procedures for EL, quantifying its impact with regards to pricing or risk adjusted profitability measures, such as RARORAC.
In this paper, a practically oriented, top-down approach to assess the quality of EL by backtesting with actually observed risk impact on capital is introduced. In a first step, the concept of risk expenses (“Cost of Risk”) has to be extended beyond the classical provisioning (P&L) view, towards a more adequate capital consumption approach (“Impact of Risk”, IoR). On this basis, the difference between parameter-based EL and actually reported “Impact of Risk” is decomposed into its key components (PL Backtest and NPL Backtest).
The proposed method will deepen the understanding of practical properties of EL, aligns the EL with actually observed risk impact on capital and has the potential to improve the quality of EL-based business decisions. Besides assumptions on the stability of parameter estimates and default identification, there are no further requirements on the underlying credit risk parameters. The method is robust irrespective whether parameters are simple, expert based values or highly predictive and perfectly calibrated IRBA compliant methods.
arxiv.org/ftp/arxiv/papers/1211/1211.4946.pdf
Wolfgang Reitgruber123
Abstract
The dependency structure of credit risk parameters is a key driver for capital consumption and receives regulatory and scientific attention. The impact of parameter imperfections on the quality of expected loss (EL) in the sense of a fair, unbiased estimate of risk expenses however is barely covered. So far there are no established backtesting procedures for EL, quantifying its impact with regards to pricing or risk adjusted profitability measures, such as RARORAC.
In this paper, a practically oriented, top-down approach to assess the quality of EL by backtesting with actually observed risk impact on capital is introduced. In a first step, the concept of risk expenses (“Cost of Risk”) has to be extended beyond the classical provisioning (P&L) view, towards a more adequate capital consumption approach (“Impact of Risk”, IoR). On this basis, the difference between parameter-based EL and actually reported “Impact of Risk” is decomposed into its key components (PL Backtest and NPL Backtest).
The proposed method will deepen the understanding of practical properties of EL, aligns the EL with actually observed risk impact on capital and has the potential to improve the quality of EL-based business decisions. Besides assumptions on the stability of parameter estimates and default identification, there are no further requirements on the underlying credit risk parameters. The method is robust irrespective whether parameters are simple, expert based values or highly predictive and perfectly calibrated IRBA compliant methods.
arxiv.org/ftp/arxiv/papers/1211/1211.4946.pdf