Financial Risk Manager Part 2

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Explanation:

Under the Basel II IRB approach, the credit risk capital (Unexpected Loss) is calculated at the 99.9th percentile.

First, we calculate the Probability of Default (PD). Given:

Expected Loss (EL) = EUR 4.2 million
Exposure at Default (EAD) = EUR 200 million
Expected recovery rate = 30%, so Loss Given Default (LGD) = 1 - 0.30 = 0.70

Since EL = PD * LGD * EAD: 4.2 million = PD * 0.70 * 200 million 4.2 million = PD * 140 million PD = 4.2 / 140 = 0.03 = 3%

Next, we calculate the Unexpected Loss (UL) using the Worst Case Default Rate (WCDR) at the 99.9th percentile, which is given as 9.87%. UL = (WCDR - PD) * LGD * EAD UL = (0.0987 - 0.03) * 0.70 * 200 million UL = 0.0687 * 140 million = 9.618 million

The correct estimate for the credit risk capital is approximately EUR 9.62 million.

Explanation:

Under the Basel II IRB approach, the credit risk capital (Unexpected Loss) is calculated at the 99.9th percentile.

First, we calculate the Probability of Default (PD). Given:

Expected Loss (EL) = EUR 4.2 million
Exposure at Default (EAD) = EUR 200 million
Expected recovery rate = 30%, so Loss Given Default (LGD) = 1 - 0.30 = 0.70

Since EL = PD * LGD * EAD: 4.2 million = PD * 0.70 * 200 million 4.2 million = PD * 140 million PD = 4.2 / 140 = 0.03 = 3%

The correct estimate for the credit risk capital is approximately EUR 9.62 million.

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Question A regulatory analyst at a large bank is preparing a report of the bank’s credit risk capital for the current year and uses the Basel II IRB approach for making the calculation. As part of this process, the analyst identifies a portfolio of credit exposures of equal size that are held by borrowers with the same probability of default. The analyst has collected the following information about the portfolio:

Exposure at default EUR 200 million
1-year expected loss on the portfolio EUR 4.2 million
Expected recovery rate on a defaulted credit 30.00%
1-year portfolio default rate at the 95<sup>th</sup> percentile 5.66%
1-year portfolio default rate at the 99.9<sup>th</sup> percentile 9.87%

What is the correct estimate of the Basel II credit risk capital that the bank should reserve for this portfolio?

Exposure at default	EUR 200 million
1-year expected loss on the portfolio	EUR 4.2 million
Expected recovery rate on a defaulted credit	30.00%
1-year portfolio default rate at the 95<sup>th</sup> percentile	5.66%
1-year portfolio default rate at the 99.9<sup>th</sup> percentile	9.87%

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Last updated: July 5, 2026 at 07:29

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