Unexpected Loss and Economic Capital Buffer
In the previous articles, we have seen how we can use exposure at default (EAD), loss given default (LGD), and probability of default to calculate the value of expected losses. However, it needs to be understood that expected losses are at best a crude estimate of the amount of money that would be required to mitigate the losses.
Any organization cannot solely rely on the expected loss number. This is because the actual losses would exceed the estimated losses roughly 50% of the time! This is the reason that organizations also need to think about the concept of unexpected losses and how they affect the risk management processes at banks.
What is Unexpected Loss?
Unexpected loss is the value of the loss, which may exceed the expected loss, which may occur in any particular year. Lets understand this with the help of an example. If company A budgets $40,000 for credit losses in any particular year and in that year, the actual losses turn out to be $55,000, then the additional $15,000 are said to be "unexpected losses".
Why Is It Important To Account For Unexpected Loss?
Unexpected loss is considered to be an important figure in order to evaluate the performance of the credit risk management function. This is because if the firm is suffering from unexpected losses every year, then obviously they are calculating expected losses in the wrong way. Also, the company has to be sure about how big their unexpected losses can be. In most scenarios, unexpected losses are covered by the equity shareholders of the company. Hence, if the unexpected loss is more than the valuation of the equity in a company, it can lead to bankruptcy within a very short period of time.
How Is Unexpected Loss Calculated?
The calculation of unexpected losses is quite complicated. This is because it is not possible to directly calculate the unexpected loss. Instead, it can be estimated using a simulated range of expected losses. The details have been mentioned below:
It is important to realize that since the expected loss distribution is based over a period of time, the unexpected loss calculation is also valid only for that period of time. In the long run, companies may need more or less economic capital and that has to be calculated at predefined periods of time.
The fact of the matter is that it is impossible to predict with accuracy the loss that any company may have to face in the long run. However, using advanced statistical techniques, it is possible to be able to meet the solvency requirements of the firm with a high degree of certainty.
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