Question

Banks’ expected losses on their loan portfolio are critical for pricing transactions and has an important role in loan portfolio management. Given the current financial situation, the global markets are facing, what adjustments banks are required to make to their allocated capital to price loans more accurately?

Answer 1

Bank expected loss on the loan portfolio are based upon three parameters and those will be including the exposure at default along with probability of default and losses given default so these three parameters will be used to calculate the overall all bank expected loss on their portfolio.

In the current financial situation, when the Global markets are facing a lot of uncertainty due to emergence of the coronavirus because the credit system has taken a hit and liquidity in the credit system has completely dried up and it has made of various small businesses along with debt ridden businesses vulnerable to default on their loans so the banks are needed to adjust their estimation of receipts of the income from these distressed organisation to a lower extent in order to increase the probability of losses and they will also be increase the exposure of default so the overall expected loss on the loan portfolios are going to get bigger in this economic cycle.

There is an expectation of impending recession by many of the international organisations and it can be visible through lack of credit and lack of liquidity in financial system, as Central Bank have cut down the interest rates in anticipation of a recession. There is a likelihood of large number of smaller entities and financially distressed entities to default on their loans so bank should be increasing the expected losses on their loan portfolio as a conservative approach in order to discount the negative factors arising out of economic cycle in its books of accounts so these are the adjustments the banks are required to make to their allocated capital to price loans more accurately by increasing all the three elements which are exposure at default along with probability of default and losses given default which will be enlarge the expected credit loss of the bank.