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Measuring Provisions for Collateralised Retail Lending

by Cho-Hoi Hui of the Hong Kong Monetary Authority,
Chi-Fai Lo of the Chinese University of Hong Kong,
Tak-Chuen Wong of the Hong Kong Monetary Authority, and
Po-Kong Man of the Chinese University of Hong Kong

July 2006

Abstract: This paper develops a simple model based on an options approach to measure provisions covering expected losses of collateralised retail lending due to default. The measurement of provisions against expected losses of retail lending secured by collateral is important for improving the capital adequacy framework for banks. The numerical results based on the model show that the loan-to-value ratio, correlation between the collateral value and the probability of default of borrowers in the pool, volatility of the collateral value, mean-reverting process of the probability of default and time horizon are the important factors for measuring provisions.

JEL Classification: C60, G13, G28.

Keywords: Credit risk, Basel II, Provisioning.

Published in: Journal of Economics and Business, Vol. 58, No 4, (July/August 2006), pp. 343-361.

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