Edited by Kern Alexander and Rahul Dhumale
Chapter 5: Considerations on Developing and Validating Expected Loss (EL) Methodologies
Gianluca Riccio1, 2 Editors’ abstract: Gianluca Riccio analyses the Basel Accords’ (Basel II and III) expected loss measurement approach for credit and market risk. Basel III builds on Basel II’s risk-based process for calculating regulatory capital by allowing banks to use their own risk measurement parameters (i.e., loss given default) to estimate their credit, market and operational risks. Under Basel III, the regulator must approve the reliability of the banks’ risk measurement and management system in order for it to be used as a basis for calculating regulatory capital and for meeting liquidity requirements. The chapter focuses on the challenges and strategies which banks should consider when developing and validating loss given default and ratings methodologies in the absence of reliable data, and how hybrid models for measuring expected loss can provide valuable risk measurement solutions. Nevertheless, the approval of such hybrid approaches for measuring expected loss should be scrutinised closely by regulators, as expected loss measurement models proved to be flawed in 2007 when the credit crisis began. Such models generally did not take into account correlations across asset classes and counter-party credit risks in the wholesale funding markets. The crisis demonstrated major weaknesses in Basel II’s expected loss measurements because they were based on limited data distributions, underestimated capital for the trading book, and ignored macro-prudential factors, such as investor herding during periods of market stress. Basel III places less relative importance on expected loss models by requiring much higher tier one capital and linking the calculation of...
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