Once specified, the correlations are used to combine individual credit losses in different states into a loss distribution for the entire portfolio based on the credit risk model's underlying assumptions. Credit risk models as a risk management tool A portfolio's credit loss distribution is a key analytical tool for credit risk management. Once determined, this loss distribution gives a banker a complete forecast of possible portfolio credit losses over the coming year. For example, the mean of the distribution is the expected value of potential credit losses and could be used directly to determine the level of loan loss provisions that should be held for the loan portfolio. Furthermore, the higher percentiles of the portfolio loss distribution can be used to determine the economic capital necessary for the portfolio.
Economic capital is the buffer of reserves banks hold to guard against unexpected loan losses.
Economic capital is typically set high enough that unexpected credit losses are very unlikely to exhaust it. Furthermore, the loss distribution provides the banker with a diagnostic tool for examining the impact of changes in credit concentrations on the entire portfolio's potential losses. Under the Committee's recently proposed revisions to the 1988 Basel Capital Accord, national bank supervisors would permit banks that have met certain supervisory criteria to use their own internal models to determine certain inputs to their regulatory capital requirements. However, the new guidelines will not permit banks to set their capital requirements solely on the basis of their own credit risk models. Looking ahead The field of credit risk modeling for commercial loans is still developing, but its core principles have been readily accepted by banks and their supervisors.