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Credit Risk Assessment Considering Variations in Exposure: Application to Commitment Lines

Author

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  • Shigeaki Fujiwara

    (Deputy Director and Economist, Institute for Monetary and Economic Studies (currently, Director and Economist, Financial Systems and Bank Examination Department), Bank of Japan (E-mail: shigeaki.fujiwara@boj.or.jp))

Abstract

Given the worldwide financial market confusion caused by the subprime mortgage problem and the increase in credit line contracts with relaxed covenants, there have been cases in which financial institutions are facing a demand to provide additional credit to securitized vehicles with heightened liquidity and credit risks. These are typical examples demonstrating the importance of risk management considering variations in exposure. There are also calls for incorporation of future variations in exposure into the model for the Basel II advanced internal ratings-based approach. This paper adopts commitment lines as a credit provision with variable exposure and constructs a credit risk model whereby stochastic new borrowing demand is linked to changes in a firm's asset value. Through simulations, the paper then considers the interdependence among exposure at default, probability of default, loss given default, expected loss, and unexpected loss. The paper also prepares a simple model for the covenants, and verifies the influence of the rigidness of covenants on expected loss and other risk factors.

Suggested Citation

  • Shigeaki Fujiwara, 2009. "Credit Risk Assessment Considering Variations in Exposure: Application to Commitment Lines," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 27(1), pages 171-194, November.
    • Handle: RePEc:ime:imemes:v:27:y:2009:i:1:p:171-194
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    References listed on IDEAS

    as
    1. Satoshi Yamashita & Toshinao Yoshiba, 2007. "Analytical solutions for expected and unexpected losses with an additional loan," IMES Discussion Paper Series 07-E-21, Institute for Monetary and Economic Studies, Bank of Japan.
    2. Bernd Engelmann & Robert Rauhmeier (ed.), 2006. "The Basel II Risk Parameters," Springer Books, Springer, number 978-3-540-33087-5, October.
    3. Martin, J. Spencer & Santomero, Anthony M., 1997. "Investment opportunities and corporate demand for lines of credit," Journal of Banking & Finance, Elsevier, vol. 21(10), pages 1331-1350, October.
    4. Gregorio Moral, 2006. "EAD Estimates for Facilities with Explicit Limits," Springer Books, in: Bernd Engelmann & Robert Rauhmeier (ed.), The Basel II Risk Parameters, chapter 0, pages 197-242, Springer.
    5. Campbell, Tim S, 1978. "A Model of the Market for Lines of Credit," Journal of Finance, American Finance Association, vol. 33(1), pages 231-244, March.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Commitment lines; Probability of default; Loss given default; Exposure at default; Expected loss; Unexpected loss;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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