BBVA in 2012

The economic cycle in PDThe current economic crisis has revealed the importance of a proper anticipation in riskmanagement. In this context, excess cyclicality of risk measurements has been identifiedas one of the causes of the instability of the metrics of financial institutions. BBVA hasalways been committed to estimating average cycle parameters that mitigate the effects ofeconomic-financial turbulence in credit risk measurement.The probability of default varies according to the cycle: it is greater during recessions andlower during expansions. In general, financial institutions do not have internal informationon defaults covering a sufficiently long period of time to serve as an observation of thebehavior of portfolios over a complete cycle. That is why adjustments have to be made to theinternal data. The adjustment process to translate the default rates observed empirically intoaverage default rates is known as cycle adjustment. The cycle adjustment uses sufficientlylong economic series related to the default of portfolios, and their behavior is compared withthat of the default events in the Entity’s portfolios. Any differences between past and futureeconomic cycles may also be taken into account, thus resulting in a certain prospectiveapproach.10Cycle adjustment mechanismDefaultratioCycle averageAverage forobserved period1 6 11 16 21 26Chart 10 illustrates how the cycle adjustment mechanism works. It shows the hypotheticalevolution of a series of default events over a sufficiently long period of time to be considered toinclude at least one economic cycle. The cycle adjustment model used by BBVA extrapolates theperformance of this series of default events to internal data, based on the relationship between theseries over one entire cycle and the observation period.Loss given default (LGD)Loss given default (LGD) is another of the key metrics used in quantitative risk analysis. It is definedas the percentage exposure at risk that is not expected to be recovered in the event of default.BBVA basically uses two approaches to estimate LGD. The most common one is known as“workout LGD”, in which estimates are based on the historical information observed by the Entity,by discounting the flows observed throughout the recovery process of the contracts that havebeen in default at some point. In portfolios with a low rate of default (low default portfolio, orLDP), there is insufficient historical experience to make a robust estimate using the workout LGDmethod, so external sources of information have to be combined with internal data to obtain arepresentative rate of loss given default.Credit risk97