Operations of banks are typically dominated by the granting of credit and therefore, credit risk is the largest individual risk in the banking system by far. In recent years, central banks and commercial banks have begun to use models that make it possible to more coherently probe the development of the banks’ credit risks on basis of different assumptions and events.
In its stability analysis, the Riksbank uses a portfolio model to assess credit risk in the Swedish banking system. The idea behind this approach is that the resilience of the banks is reflected in the size of the capital buffer they hold in relation to the credit risk measured in their loan portfolios. A portfolio model makes it possible to calculate the probability that loan losses of various sizes may arise in existing portfolios. Information regarding the composition of the portfolio, the probability of default, and recoveries is needed in order to calculate the risk in the loan portfolio.
Two measures are usually used to quantify the credit losses the banks may incur. One is a measure of the expected loss that indicates how much a bank can expect to lose in its current credit portfolio. This is calculated by multiplying the likelihood of default by exposure at default (exposure*LGD, where LGD is Loss Given Default). The other is a measure of the size of the losses that can occur in addition to the expected losses and for which the bank must have capital cover (required risk capital). In this way, it is possible to study how changes in the credit quality of the banks’ borrowers influence the credit risk in the banks’ loan portfolios.