Unexpected loss, expected profit, and economic capital: A note on economic capital for credit risk incorporating interest income, expenses, losses, and ROE target

We compare the traditional calculation of economic capital for credit default losses with a more comprehensive one based on the bank's (net) profit from credit business as accounted for in the bank's P&L statement. In this comparison, we integrate shareholders' perspective into the bank's calculation of economic capital. Shareholders' ROE target affects credit pricing in terms of interest rates to be charged in the lending business and hence affects the profit distribution. We show that economic capital needed to buffer losses as of the P&L statement is strictly less than the unexpected loss in EaD from defaults.