A Simplified Method for Calculating the Credit Risk of Lending Portfolios
AbstractThe common practice for managing the credit risk of lending portfolios is to the calculate the maximum loss within the "value at risk" framework. Most financial institutions use large-scale Monte Carlo simulations to do this. However, such simulations may impose heavy calculation loads. This paper proposes a simplified method that approximates maximum loss with minimal simulation burden. Our method divides a portfolio into subportfolios at each credit rating level and calculates the maximum loss of each subportfolio. We assume that the subportfolio's structure provokes little fluctuation in the ratio between the maximum loss and the standard deviation. We therefore begin with a subportfolio in which each exposure is of the same amount (a homogeneous subportfolio). Simple calculations provide the standard deviation for both the heterogeneous subportfolio whose risk is to be measured and the homogeneous subportfolio. The maximum loss for the homogeneous subportfolio can be obtained by using analytical techniques rather than simulations. The maximum loss for a heterogeneous subportfolio is then approximated by multiplying the ratio of the maximum loss and standard deviation of the homogeneous subportfolio by the standard deviation of the heterogeneous subportfolio. Simulation examples indicate that this approximation is effective in all portfolios except those including extremely large exposures. This paper also describes a technique for using the total maximum loss of all subportfolios to find the maximum loss for the entire portfolio.
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Bibliographic InfoArticle provided by Institute for Monetary and Economic Studies, Bank of Japan in its journal Monetary and Economic Studies.
Volume (Year): 18 (2000)
Issue (Month): 2 (December)
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Find related papers by JEL classification:
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
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