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**This article proposes a framework for estimating credit conversion factors (CCFs) in measures of exposure at default. Based on the Basel II Advanced IRB approach, the proposed framework can be a reference for both credit risk practitioners and regulators.
(ProQuest: ... denotes formulae omitted.)
BASEL II ALLOWS banks to use their own measures of credit risk to calculate appropriate levels of economic capital. Prior to implementing this Advanced IRB (internal ratings based) approach, however, the bank must model three major credit risk parameters:
1. Probability of default (PD), which is the probability that a borrower will default in the next year.
2. Exposure at default (EAD), which is the bank's exposure to borrowers upon their default.
3. Loss given default (LGD), which is the percentage of EAD that the bank ends up losing.
As outlined by the Basel Committee on Banking Supervision in June 2006, Basel II requires banks to consider on- or off-balance-sheet exposures in their own EAD estimates. For on-balance-sheet exposures, the following formula can be adopted to estimate EAD:
1 EAD = Ave(CCF) x NB,
where NB is the current net book balance for each obligation, and CCF is the credit conversion factor specified for on-balance-sheet exposures. The following empirical formula can be used to estimate CCF:
2 CCF = (NB + Accrued Interest + Accrued Fee)/NB.
Usually, accrued interest and accrued fee are equal to or greater than zero. Therefore, CCF is always equal to or slightly greater than 1. The empirical CCF expressed in equation 2 is an obligation level and can be considered a random variable with some statistical characteristics. A statistic of CCF at the portfolio level, as expressed in equation 1, can be used to capture such characteristics.
The Advanced IRB approach emphasizes that banks should use estimates of off-balance-sheet items and reflect the probability of additional drawings by borrowers up to and after a default event is triggered. In this case, EAD is defined as
3 EAD = NB + Ave(LEQ) x (NE - NB),
where average LEQ is the mean of the loan equivalency factor in a special bucket based on rating grade and/or other factors that will be determined by statistical characteristics or business practice. In equation 3, net exposure (NE) minus...