Credit Risk Management Practice Exam

In the context of credit risk, what does probability of default influence in economic capital calculations?

1. Expected earnings

2. Expected loss

3. Loan utilization rate

4. Expense ratio

The correct answer is: Expected loss

In the realm of credit risk, the probability of default (PD) directly impacts the expected loss calculation. Expected loss is derived from the potential loss that a financial institution anticipates incurring due to borrowers not fulfilling their repayment obligations. This calculation is typically represented as: Expected Loss (EL) = Probability of Default (PD) × Loss Given Default (LGD) × Exposure at Default (EAD). Here, the probability of default acts as a crucial factor, as it determines the likelihood that a borrower will fail to repay the loan. A higher probability of default indicates a greater risk of loss, which consequently raises the expected loss estimation. This is essential in economic capital calculations since institutions must set aside enough capital to cover potential losses, ensuring they maintain financial stability and meet regulatory requirements. The other choices do not inherently relate to the calculation of expected losses in the same direct manner. Expected earnings might reflect the overall revenue, loan utilization rate pertains to how much of the approved credit is being used, and expense ratio focuses on operational costs rather than risk assessment directly projected by the probability of default.