Simulating Credit Loss Distributions: Empirical Versus the Vasicek Model

Natasa Milonas and Gary van Vuuren
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Natasa Milonas: Department of Mathematics and Applied Mathematics, University of Pretoria, Pretoria, South Africa
Gary van Vuuren: Centre for Business Mathematics and Informatics, North-West University, Potchefstroom, 2351, South Africa

International Journal of Economics and Financial Issues, 2024, vol. 14, issue 2, 77-88

Abstract: Because credit losses can be substantial, managing credit risk is a focus area of risk measurement and management. It is important for financial institutions to select credit risk models that accurately forecast losses. The Basel Committee on Banking Supervision (BCBS) chose the closed-form single risk factor Vasicek model for regulatory capital calculations. In this article, its forecast accuracy is compared with empirical loss distributions using simulated probabilities of default and losses given default. The effect of altering probabilities of default on asset correlations was analysed and how this affects credit portfolio loss distributions. The robustness of the Vasicek model against five different portfolios with unique compositions was explored: results highlight two key findings. Firstly, the Vasicek model is a good approximation of credit losses for a portfolio that does not contain dominating loans (it is, after all, based on the assumption of large-scale homogeneity). Secondly, the Vasicek model is a good approximation for expected loss (ELs) but lacks accuracy when determining extreme unexpected losses (ULs). Finally, credit capital requirements as a function of two variables are presented which reveals novel ways of viewing these values.

Keywords: Credit risk; Vasicek Distribution; ASRF Model (search for similar items in EconPapers)
JEL-codes: C3 C5 G1 M4 (search for similar items in EconPapers)
Date: 2024
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