Explanation:
A fundamental challenge in deriving economic capital using bottom-up models for credit risk is that most credit models calculate risk parameters (like PD, LGD, EAD) over a one-year time horizon. For illiquid assets that cannot be quickly disposed of, estimating losses and capital requirements over a longer period (the true holding period) becomes necessary but is difficult because models are typically calibrated for just one year.
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Q.60 Fusion Bank is applying a bottom-up approach to quantify its credit risk in order to derive economic capital. What challenge is Fusion Bank likely to face with this approach, particularly when it involves credit assets viewed as illiquid?
A
The approach may lead to an underestimation of credit losses due to an insufficient focus on portfolio diversification
B
The methodology often requires estimation of losses over a period longer than one year, although the models are typically designed for one-year estimates
C
The approach might require additional resources as it separates credit risk from market and operational risks, each managed independently
D
Illiquidity of assets implies that expected losses can be hedged, nullifying the need to calculate economic capital for those assets
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