The three important factors used to calculate economic capital for credit risk include the probability of default (PD), which indicates the likelihood that a borrower will default on contractual payments; exposure at default (EAD), which is the predicted amount of loss when a borrower defaults; and loss given default (LGD), which is the estimated unrecoverable portion after selling the collateral. These factors help in measuring and preparing for the credit risk exposure.

A is incorrect. The credit conversion factor is related to the credit equivalent amount of a contingent exposure, expected exposure is a measure associated with derivatives, and probability of recovery is not a standard term used in economic capital calculations.

B is incorrect. The liquidity coverage ratio and net stable funding ratio are regulatory measures that pertain to a bank’s liquidity and funding structure, not credit risk. The loss avoidance rate is not a widely recognized term for economic capital computations.

D is incorrect. Default adjustable rate is not a term used within the context of economic capital for credit risk. Mark-to-market exposure is more related to market risk and valuations. Salvage value rate is not a term typically used in economic capital assessments for credit risk.

Things to Remember

• The probability of default (PD), exposure at default (EAD), and loss given default (LGD) are foundational components for calculating economic capital for credit risk.
• PD represents the likelihood of a borrower’s default, EAD is the bank’s financial exposure at the point of default, and LGD estimates the unrecoverable loss percentage.
• Accurate estimation of these parameters is crucial for assessing the economic capital required to buffer against potential credit losses.