Abstract
Banks manage credit risk using expected loss to set the loss provisions and using unexpected loss (economic capital) to set the capital buffer. How the asset correlations of the loan portfolios affect economic capital will be the main focus of this paper. In addition, we consider contagion and liquidity risk in conjunction with credit risk to build a complete model. Based on CreditPortfolioView model, we consider the relationship between macroeconomic variables and the probability of default. Monte Carlo simulation is applied to generate the loss distribution of 9 loans of 35 Taiwanese banks, and we analyze the impact of the correlations on VaR. We then compute the risk contribution for each loan portfolio and analyze the relationship between risk contribution and corresponding correlation. In addition, we also investigate the correlations in the long run and short run, and analyze the differences between corresponding credit loss distributions. Then, based on the simulated credit loss distribution, we consider the impact of contagion risk and liquidity risk. Loss distribution of the Taiwanese banking system is generated and we compute the risk contribution from it for each bank. The results show that correlations do not have relevant impact on risk contributions, which may also depend on the probability of default and exposure at default. The correlations in the long run are higher than those in the short run and so is the corresponding economic capital Moreover, liquidity risk has more impact on the entire loss distribution than credit risk, and it also plays a critical role in the risk contribution of banks.