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The dependency structure of credit risk parameters is a key driver forcapital consumption and receives regulatory and scientific attention. Theimpact of parameter imperfections on the quality of expected loss (EL) in thesense of a fair, unbiased estimate of risk expenses however is barely covered.So far there are no established backtesting procedures for EL, quantifying itsimpact with regards to pricing or risk adjusted profitability measures. In thispaper, a practically oriented, top-down approach to assess the quality of EL bybacktesting with a properly defined risk measure is introduced. In a firststep, the concept of risk expenses (Cost of Risk) has to be extended beyond theclassical provisioning view, towards a more adequate capital consumptionapproach (Impact of Risk, IoR). On this basis, the difference betweenparameter-based EL and actually reported Impact of Risk is decomposed into itskey components. The proposed method will deepen the understanding of practicalproperties of EL, reconciles the EL with a clearly defined and observable riskmeasure and provides a link between upcoming IFRS 9 accounting standards forloan loss provisioning with IRBA regulatory capital requirements. The method isrobust irrespective whether parameters are simple, expert based values orhighly predictive and perfectly calibrated IRBA compliant methods, as long asparameters and default identification procedures are stable.

The Calculus of Expected Loss: Backtesting Parameter-Based Expected Loss in a Basel II Framework