Applications of Credit Risk Models
Credit risk models are not just academic theory. They are the engine value of modern banking.
1. Regulatory Capital (Basel III)
Banks must use models to calculate how much capital to hold against loans.
- RWA (Risk Weighted Assets): A 100 Crore loan to a startup (High PD) requires more capital than a 100 Crore loan to the Government (Zero PD).
- Formula: Capital = f(PD, LGD, EAD, Correlation).
- If a model underestimates risk (PD), the bank holds too little capital and might fail (like in 2008).
2. Risk-Adjusted Loan Pricing
How much interest should a bank charge?
- Rate = Cost of Funds + Admin Cost + Expected Loss + Profit Margin.
- The Expected Loss part comes directly from the credit model.
- RAROC (Risk Adjusted Return on Capital): Used to judge if a loan is profitable after accounting for the risk capital required.
3. Pricing Credit Derivatives (CDS)
A Credit Default Swap (CDS) is insurance against default.
- To price a CDS (i.e., what premium to charge), you must have an Intensity Model (Hazard Rate) to know the probability of paying out the insurance.
4. Portfolio Management
- Banks use models to look at Correlations.
- If a bank lends to 10 Steel companies, their default risks are highly correlated. The model flags this Concentration Risk and forces the bank to diversify.
Note
The 2008 Crisis: The crisis happened partly because models (Gaussian Copula) underestimated the Correlation of defaults in Home Mortgages. Everyone thought defaults were independent; in reality, they all defaulted together.
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