Difficulty of measuring credit risk

Measuring credit risk on a portfolio basis is difficult. Banks traditionally measure
credit exposures by obligor and industry. They have only recently attempted to define
risk quantitatively in a portfolio context, e.g. a Value-at-Risk (VaR) framework.3
Although banks have begun to develop internally, or purchase, systems that measure
VaR for credit, bank managements do not yet have confidence in the risk measures
the systems produce. In particular, measured risk levels depend heavily on underlying
assumptions (default correlations, amount outstanding at time of default,
recovery rates upon default, etc.), and risk managers often do not have great
confidence in those parameters. Since credit derivatives exist principally to allow for
the effective transfer of credit risk, the difficulty in measuring credit risk and the
absence of confidence in the results of risk measurement have appropriately made
banks cautious about using credit derivatives. Such difficulties have also made bank
supervisors cautious about the use of banks’ internal credit risk models for regulatory
capital purposes.
Measurement difficulties explain why banks have not, until very recently, tried to
implement measures to calculate Value-at-Risk (VaR) for credit. The VaR concept,
used extensively for market risk, has become so well accepted that bank supervisors
allow such measures to determine capital requirements for trading portfolios.4 The
models created to measure credit risk are new, and have yet to face the test of an
economic downturn. Results of different credit risk models, using the same data, can
vary widely. Until banks have greater confidence in parameter inputs used to measure
the credit risk in their portfolios, they will, and should, exercise caution in using
credit derivatives to manage risk on a portfolio basis. Such models can only complement,
but not replace, the sound judgment of seasoned credit risk managers.