Part III Quantitative Capital Requirements, 6 The Definition of Default, Loss Distribution, Expected and Unexpected Loss, and Provisioning in the Context of Credit Risk

Abstract

This chapter evaluates the principles for assessing credit risk, the consequences this has for capital requirements, and the fundamental approach that is chosen for all banks in this area. Absorbing losses is one of the functions of bank capital. As regards the credit risk concerning the bank’s exposures, it can generally be argued that banks will suffer losses on their credit portfolios due to counterparties failing to pay interest, the principal or costs incurred by the bank and attributable to the relevant loans. Banks will by nature always be faced with such losses, the only question of when they will occur, and their magnitude is an issue that will have to be dealt with in the context of credit risk management. The chapter then differentiates between manifest losses, expected losses, and unexpected losses. It also looks at the capital conservation buffer (CCB) introduced by Basel III; the definition of default in European banking law; and credit risk adjustments. Finally, the chapter considers the revisions to Capital Requirements Regulation (CRR) to address non-performing exposures.