Financial Crises and Credit Risk Capital for Buy and Hold Investors

Measuring portfolio losses on the basis of market prices may not be meaningful for buy and hold investors, even less so in periods of market turmoil. In this paper, we propose a new methodology to assess the potential loss, and the corresponding capital allocation, faced by buy and hold investors in their credit portfolios. Our method does not rely on current market prices and employs, as a primary input, historical default frequencies that allow us to account for downturn scenarios as severe as the Great Depression. Our derivation of credit risk capital does not rely on simulations nor distributional assumptions which makes it quick and easy to implement. As we focus on exposures held to maturity, our approach should prove particularly useful to commercial banks, life insurers and pension funds. We conclude the paper with a comparison of our risk measures with those derived under Basel II, the new and controversial regulatory framework for bank capital