PrecisionLender uses your assumptions in order to determine the Risk Adjusted Return on Risk Adjusted Capital (RAROC), which is referred to as ROE in PrecisionLender. An important assumption is the capital associated with a particular risk rating and the amount of loan loss reserves.
In this article we will discuss the methods used to determine capital, loan loss reserves and guarantee factor used when a loan is guaranteed.
- The amount of Economic Capital needed is based on the Projected Average Balance of a loan during its amortization and is the sum of Unmitigated Capital and Credit Capital.
- Unmitigated Capital
- There are events where a financial institution has limited ability to make decisions to protect itself.
- A tornado or hurricane that damages a branch
- International shocks that move financial markets
- The literature from the Basel Committee on Bank Supervision provides guidance on how this risk should be measured based on an institution’s gross interest income and average assets.
- Amount of capital needed to reflect operational and market risk.
- Credit Capital
- The suggested method to calculate this is by using the credit migration of the institution’s loan portfolio.
- Typically examined over a one year period.
- Amount of capital required based on the credit risk of the loan.
- Will vary based on the risk grade of the loan and its duration.
- Using Basel guidelines credit capital is the amount of funds needed to ensure that a bank has 99.9% confidence it has sufficient reserves for a particular risk grade.
Calculating Credit Capital
- We partner with you in order to conduct an analysis of your credit experience in order to recommend the following assumptions for our clients to consider for adoption:
- Annual Loss (expected loss)
- Credit Capital (unexpected loss)
- Guarantor Factor
For a more detailed explanation on PrecisionLender’s approach in determining Annual Loss, Credit Capital, and the impact of Guarantors on loan profitability in respect to Probability of Default (PD) and Loss Given Default (LGD) assumptions, please see our article How To Determine Capital Calculation.