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Estimating Credit Risk Capital: What's the Use?

PAUL KUPIEC (Deputy division chief of the Monetary and Exchange Affairs Department at the International Monetary Fund in Washington, DC.)

Journal of Risk Finance

ISSN: 1526-5943

Article publication date: 1 February 2001

484

Abstract

Risk capital is an important input for management functions. Capital structure decisions, capital budgeting, and ex post performance measurement require different measures of risk capital. While it has become common to estimate risk capital using VaR models, it is not clear that VaR‐based capital estimates are optimal for applications to management functions (e.g. risk management, capital budgeting, performance measurement, or regulation). This article considers three typical problems that require an estimate of credit risk capital: an optimal equity capital allocation; an optimal capital allocation for capital budgeting decisions; and an optimal capital allocation to remove moral hazard incentives from a compensation contract based on ex post performance. The optimal credit risk capital allocation is different for each problem and is never consistent with a credit VaR estimate of unexpected loss. The results demonstrate that the optimal risk capital allocation depends on the objective.

Citation

KUPIEC, P. (2001), "Estimating Credit Risk Capital: What's the Use?", Journal of Risk Finance, Vol. 2 No. 3, pp. 17-34. https://doi.org/10.1108/eb043465

Publisher

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MCB UP Ltd

Copyright © 2001, MCB UP Limited

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