Solution

There are two approaches to measure credit risk: one is use of credit ratings (external and /or internal) - Banks should have a comprehensive risk scoring / rating system that serves as a single point indicator of diverse risk factors of a counterparty and for taking credit decisions in a consistent manner. Another method is estimating the loan loss i.e. expected loss (t he average loss that the organization expects from exposure over a fixed time period, usually a year) using  3 integral components (known as risk components) that are required to be estimated for credit risk quantification. o   Probability of Default (PD): It refers to the probability/risk/chance of a borrower defaulting on the payment of the credit obligations, within a given time horizon, usually one year. o   Loss Given Default (LGD): It refers to the loss likely to be suffered in the event of a default occurring in an exposure. It takes into account the number of recoveries likely to be made post default o   Exposure at Default (EAD): It refers to the amount that is exposed to the default risk. It is usually the amount outstanding as well as undrawn commitment that is expected to be drawn by the time of default.