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When uncertainty decouples expected and unexpected losses

John Juselius and Nikola Tarashev

No 995, BIS Working Papers from Bank for International Settlements

Abstract: A parsimonious extension of a well-known portfolio credit-risk model allows us to study a salient stylized fact – abrupt switches between high- and low-loss phases – from a risk-management perspective. As uncertainty about phase switches increases, expected losses decouple from unexpected losses, which reflect a high percentile of the loss distribution. Banks that ignore this decoupling have shortfalls of loss-absorbing resources, which is more detrimental if the portfolio is more diversified within a phase. Likewise, the risk-management benefits of improving phase-switch forecasts increase with diversification. The analysis of these findings leads us to an empirical method for comparing the degree of within-phase default clustering across portfolios.

Keywords: expected loss provisioning; bank capital; unexpected losses; credit cycles; portfolio credit risk. (search for similar items in EconPapers)
JEL-codes: G21 G28 G32 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2022-01
New Economics Papers: this item is included in nep-ban, nep-rmg and nep-upt
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