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Credit Risk Assessment Considering Variations in Exposure: Application to commitment lines

by Shigeaki Fujiwara of the Bank of Japan

February 2008

Abstract: With the worldwide financial market confusion caused by the subprime mortgage problem and the increase in credit line contracts with relaxed covenants, there are cases where financial institutions are facing demands to provide additional credit to securitized vehicles with heightened liquidity and credit risks. These are typical examples demonstrating the importance of risk management considering variations in exposure. There are also calls for incorporation of future variations in exposure into the model for the Basel II advanced internal ratings-based approach. This paper adopts commitment lines as a credit provision with variable exposure and constructs a credit risk model whereby stochastic new borrowing demand is linked to changes in a firm's asset value. Through simulations, the paper then considers the interdependence among exposure at default, probability of default, loss given default, expected loss, and unexpected loss. The paper also prepares a simple model for the covenants, and verifies the influence of the rigidness of covenants on expected loss and other risk factors.

JEL Classification: G21, G32, G33.

Keywords: Commitment lines, Probability of default, Loss given default, Exposure at default, Expected loss, Unexpected loss.

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