Beginning paragraphs: If a borrower defaults on a loan, a bank's recovery may depend on the value of the loan collateral. The value of collateral, like the value of other assets, fluctuates with economic conditions. If the economy experiences a downturn, a bank can experience a double misfortune: many obligors default, and the value of collateral is damaged.
Conventional credit models overlook the effect of economic conditions on collateral. They allow default to vary from year to year, but they hold fixed the average value of collateral and the average level of recovery.
The distinctive feature of the credit model presented here is that an economic downturn causes damage to the value of collateral. When systematic collateral damage enters the credit model, the capital allocated to a highly collateralized loan can double or triple.
Taking collateral damage into account complicates a credit capital model. However, the results of the model can be well approximated by a function of expected loss alone. Expected loss can therefore be used as the basis of a credit capital estimate. This estimate is simpler, and can be more accurate than using the results of a conventional credit model that ignores the role of collateral damage.
