Combined, these measures reveal the expected loss, which a bank must know to underwrite and price a credit correctly, as well as to establish adequate loss reserves. However, it is the volatility of this loss and the contribution of the credit to the volatility of the bank’s cash flow on a firm-wide, portfolio basis that is crucial to evaluating capital adequacy.
As you can imagine, the process of modeling credit risk is still as much art as science for most banks, requiring many assumptions and subjective judgments as well as substantial amounts of data. Testing the sensitivity of a model’s results to these decisions and maintaining the integrity of the process from start to finish will be a constant challenge.