In credit risk, there are different types of risks which need to be analysed. These risks cannot be analysed on a standalone basis. One of the risks is the concentration risk. Some of the major concentration risks are industry or sector concentration, name concentration, region concentration, foreign currency concentration and collateral concentration. These risks which form a part of credit risk are affected by the portfolio characteristics and thus cannot be looked in insulation. The bank needs to analyse its portfolio and check whether the new credit to be given is adding the risk to its portfolio. Banks need to analyse the diversification of the portfolio. If the bank’s loan portfolio is highly correlated, then one event can trigger a series of default and it can lead to large losses for the bank. If the bank’s portfolio is diversified, then one credit event may not have a large effect on the whole portfolio and thus the bank may not have to incur such high losses. Bank must not only analyse its risk on an individual basis but portfolio risk becomes important since there is high correlation between the loans. For example, if the banks give large amount of loans to people working for the same industry and if that industry faces issue and many employees are fired, then the banks can face significant losses as its portfolio was concentrated. On an individual, the loans might not be risky but on a bank’s level, addition of one more similar loan can add to significant risk.
PD is the probability of default. This number gives the probability on whether the loan will be defaulted by the individual/corporate or not. This depends on the individual characteristics.
EAD is the exposure at default. This measures the amount which the bank is exposed to if the individual defaults as of now. Essentially it gives the loan amount.
LGD is the loss given default. Each individual/corporate might have some assets or might have given a collateral while taking the loan. Hence selling those assets or the collateral banks can recover some amount of the loss. Loss given default give the percentage on how much loan amount can be recovered from the individual or corporate given it defaults.
Expected loss is the multiplication of the three factors which are PD* EAD* LGD.
PD is affected by many factors. For individuals, it is affected by the individual current income, intent to payback, capital or present conditions. For corporate, the present cash flows and the current market conditions are important.
LGD can be affected by the collateral and the capital of the entity.
Exposure at default is affected by the loan structure. If the loan is a simple loan, then it reduces by an amount every year. Depending on the loan structure and time for which the loan has been present gives the exposure at default.