Credit risk

Credit risk is the risk of loss because counterparties fail to meet all or part of their obligations. This risk type is normally the largest risk exposure for retail banks. Credit risk includes country risk and settlement risk.

Country risk is the risk of losses arising from the economic or political circumstances in a country. Country risk also encompasses the risk of nationalisation, expropriation and debt restructuring.
Settlement risk is the risk arising from with the settlement of payments for securities, derivatives and other trades when a bank remits payments before it can ascertain that the offsetting payments have been transferred to one of the bank's accounts.

The CRD acknowledges three methods for estimating credit risk:

Standardised Approach
Internal Rating Based, Foundation (IRB F or FIRB)
Internal Rating Based, Advanced (IRB A or AIRB)

The three approaches are described below.

Standardised Approach
The Standardised Approach was introduced in Basel I (1988), and includes four different risk classes: 0%, 20%, 50% and 100%. The CRD replaces all these risk classes with a more sensitive framework based on ratings from an external credit rating agency that is able to fulfil strict criteria. The result is a more comprehensive risk-weighting framework, with risk classes ranging from 0 to 1,250%.

For example of calculation see FSA's homepage (59kb, PDF).

Internal Rating Based Approach - Foundation and Advanced
There are two versions of the IRB Approach, the Foundation and the Advanced Approach. The IRB Foundation can be used from January 1, 2007, and the IRB Advanced can be used from January 1, 2008. The main difference is that the latter permits the use of more internal inputs.

Both models build on estimations of three important components:

Probability of Default (PD), which is the probability that a borrower will default over a one-year period. The component is also known as "Expected Default Frequency" (EDF).
Loss Given Default (LGD) expresses the expected share (%) of loss on an established facility with a borrower.
Exposure at Default (EAD), or "Usage Given Default" (UGD), is the exposure at the time of default. Conversion Factor (CF) is included in the calculation of EAD.

These three parameters are multiplied together in order to calculate the Expected Loss (EL). The Expected Loss is combined with a maturity estimate and forms the basis for the required capital.
Read more about the PD, LGD, CF and EAD.

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Components and Credit risk

PD, LGD, CF & EAD These components are very important for Pillar I due to that they constitues the capital-need at the bank. Get more information about PD, LGD, CF & EAD	Credit risk Credit risk is very important for Danske Bank's capital requirements. Read more about Danske Bank's credit risk methods

Banks using the IRB Foundation Approach estimate PD based on own internal data and statistics. Banks using the IRB Advanced Approach estimate all three variables based on own internal data and statistics, which must cover minimum five years.

Model	PD	LGD	EAD
IRB Foundation	Internal	Regulator	Regulator
IRB Advanced	Internal	Internal	Internal

Use tests
It is an absolute requirement from the regulator that the IRB components (PD, LGD and EAD) used in the IRB approaches are also integrated in a bank's daily business. They should be used in the credit approval process, for pricing, for risk management decisions, in corporate governance and other functions. Some smaller divergencies are acceptable, but in general banks should use the same IRB components both when calculating the minimum capital requirement and for internal management decisions.

Credit risk aggregation
Classical portfolio theory states that a large portfolio of different assets carries a lower risk than a small portfolio with few assets. This applies also to loan portfolios. Banks with a diversified portfolio (customer segments, sectors and countries) therefore carry a lower risk than banks with less diversified portfolios.

Concentration risk is a new and highly important feature of the CRD. The Pillar I framework of CRD includes an adjustment for average concentration. Banks with a concentration lower than this average will therefore enjoy a lower capital requirement, and banks with a higher concentration will be required to hold more capital than an average bank.

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Last updated/revised on January 31, 2008

See more about Danske Bank's risk management

Risk management

Danske Bank publishes an interactive report regarding the Groups's risk and capital management.

See the interactive report for 2007