Credit Limits, Stress Testing and Model Risk for Capital Metrics

14 Pages Posted: 12 Mar 2016

See all articles by Claudio Albanese

Claudio Albanese

Global Valuation

Fabrizio Anfuso

PRA, Bank Of England

Simone Caenazzo

Global Valuation Ltd

Dimitris Karyampas

Bocconi University

Date Written: March 10, 2016

Abstract

The topics of Economic Capital modelling, reverse stress testing and credit limits are inextricably intertwined as they all focus on exceptional loss events. In this paper, we use the KVA framework in to frame these three topics within a single unified approach.

We propose setting credit limits based on an incremental KVA metric interpreted as a measure of capital consumption for each individual client. Compared to Potential Future Exposure (PFE), incremental KVA is more risk sensitive as i) it is portfolio sensitive and detects cross-selling opportunities, ii) captures wrong-way-risk, iii) accounts for idiosyncratic features such as granularity and credit risk concentration, iv) measures also other risks besides the default of the counterparty such as CVA and FVA mark-to-market losses and is suitable to generalisations driven by regulatory changes such as MVA.

A reverse stress testing exercise based on KVA metrics reveals stress scenarios of two kinds: the ones where losses are due to an idiosyncratic vulnerability of the portfolio and the ones tied to systemic risk and the credit cycle. The latter are completely missed by the PFE, although crucially important during periods of market distress.

Since different pricing models tend to diverge the most for stressed scenarios, model risk has a material impact on capital projections and, consequently, on the KVA metric. We discuss model risk comparing Gaussian interest rate models admitting arbitrarily negative rates with alternative models where rates are bounded from below.

Keywords: KVA, PFE, credit limits, stress testing

JEL Classification: C60, C61, G10, G11, G12, G13

Suggested Citation

Albanese, Claudio and Anfuso, Fabrizio and Caenazzo, Simone and Karyampas, Dimitris, Credit Limits, Stress Testing and Model Risk for Capital Metrics (March 10, 2016). Available at SSRN: https://ssrn.com/abstract=2745903 or http://dx.doi.org/10.2139/ssrn.2745903

Claudio Albanese (Contact Author)

Global Valuation ( email )

9 Devonshire Sq.
London, London EC2M 4YF
United Kingdom

Fabrizio Anfuso

PRA, Bank Of England ( email )

20 Moorgate
London, EC2R 6DA
United Kingdom

Simone Caenazzo

Global Valuation Ltd ( email )

9 Devonshire Square
London, EC2M 4YF
United Kingdom

Dimitris Karyampas

Bocconi University ( email )

Via Sarfatti, 25
Milan, MI 20136
Italy

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