Credit Risk Management Practice Exam

Which of the following is a key factor in determining economic capital for credit risk?

1. Market share

2. Probability of default

3. Interest rates

4. Loan tenure

The correct answer is: Probability of default

The key factor in determining economic capital for credit risk is the probability of default (PD). Economic capital is the amount of capital a financial institution needs to hold to cover the risk of default and ensure it can meet its obligations. Probability of default assesses the likelihood that a borrower will fail to meet their financial obligations. It is a fundamental input in credit risk models and influences how much capital is required to safeguard against potential losses due to this risk. Higher probabilities of default would require the institution to hold more capital, as they indicate a greater risk of non-payment. While market share, interest rates, and loan tenure play roles in the broader context of credit risk management, they do not directly quantify the risk of borrower default. Market share can influence competitive strategies, interest rates impact the cost of borrowing and lending dynamics, and loan tenure affects the term of loan repayment. However, none of these factors are primary in calculating the specific economic capital criteria tied to credit risk assessment, which hinges on the borrower’s likelihood of default.