Portfolio Credit Risk Management: Theory and Application
Date Issued
2008
Date
2008
Author(s)
Huang, Jia-Long
Abstract
The implementation of Basel II in 2007 has driven banks to enhance their risk management capability, and the IRB approach has become the goal that many banks are aiming for. The IRB capital calculation formula is based on many assumptions including independence between PD and LGD, no concentration risk and identical parameters applying to all countries. Popular credit risk models like CreditMetrics or CreditRisk+ also make assumptions that LGDs are constant or LGDs are independent of PDs and do not explicitly deal with the dependence issue between PD and LGD. For this reason, we try to build a joint model for PD and LGD. The PDs depend on expected stock returns, which are in turn affected by a common factor, as well as return thresholds that are determined by risk ratings. In contrast, LGDs depend on asset values and expected equity/debt ratios, in which asset values are decomposed to three categories with different guarantee powers, while expected equity/debt ratios are influenced by the common factor. The central idea of this joint model is that PD and LGD are both affected by the common factor and hence are correlated. Viewing listed companies in Taiwan as a portfolio, we could estimate all parameters of our joint model and run Monte Carlo simulation to generate portfolio’s credit loss distribution and calculate the corresponding economic capital. The simulated economic capital is larger than the economic capital under the independence assumption and is also larger than the IRB capital. In addition, to employ economic capital as the basis for risk pricing and risk adjusted performance measurement, we must allocate portfolio economic capital to individual counterparty, which requires further Monte Carlo simulations. From the simulations, we find the ranking of allocated economic capital substantially differs from the ranking of IRB capital. Our main conclusion is that banks need to explore the basic idea of IRB capital formula and use their internal data to construct economic capital models if they want to correctly measure and manage credit risks. Banks could then meet the requirement of the Pillar II in Basel II and allocate economic capital much more efficiently. Banks need to access loans according to comparative risk. Only when this is accomplished, will banks earn more risk adjusted profit. Their counterparty would also bear less financing cost. Social welfare could therefore improve.
Subjects
Credit Risk Management
Correlation
Loss Given Default
Value at Risk
Economic Capital Allocation
Type
thesis
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