Volatility and Capital: Measures of Risk

Gary Wilhite

We work in a risky business: actions we take have uncertain outcomes; investments we make have uncertain returns. We are particularly concerned about outcomes that are not as profitable as we expect them to be. High credit losses, revenue gaps, unanticipated expenses or investment declines lead to shortfalls in earnings – disappointing shareholders and lowering a bank’s stock price. Extreme losses could even deplete a bank’s equity and lead to default.

That a bank experiences some credit losses is not of itself risk. If one knew with certainty what those losses would be, they could include that amount in their pricing just as they cover other known costs. The problem is that losses are uncertain.

One can, however, state the amount of loss they expect. Expected loss (EL) is the mean value (probability-weighted average) of all the possible losses their portfolio could experience (see Figure 1). EL is not the most likely event. The nature of credit losses is that they are often relatively low, with an occasional period of much higher losses, generally associated with a recession. The possibility of high losses, although small, pulls the expected value to the right of the most likely