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A copula sample selection model for predicting multi-year LGDs and Lifetime Expected Losses

Steffen Krüger, Toni Oehme, Daniel Rösch and Harald Scheule

Journal of Empirical Finance, 2018, vol. 47, issue C, 246-262

Abstract: Recent credit risk literature has proposed (i) sample selection models for dependencies between the one-year Probability of Default (PD) and Loss Given Default (LGD), and (ii) multi-year approaches which are limited to default risk. This paper provides a model for the simultaneous prediction of continuous default times and multi-year LGDs. These measures are paramount to predict term structures of LGDs and Lifetime Expected Losses for the revised loan loss provisioning framework of IFRS 9 and US GAAP (current expected credit loss, CECL). The model includes a variation of copulas and corrects for sample selection bias of LGDs, which are only observed given a default event. We find empirical evidence that bonds which default closer to origination tend to generate higher LGDs. The model enables more precise estimates of Lifetime Expected Losses and prevents a severe underestimation in contrast to more restricted credit risk models.

Keywords: Continuous time-to-default; IFRS 9 and CECL; Lifetime Expected Loss; Loss Given Default; Multi-period; Term structure (search for similar items in EconPapers)
JEL-codes: G20 G28 C51 (search for similar items in EconPapers)
Date: 2018
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Journal of Empirical Finance is currently edited by R. T. Baillie, F. C. Palm, Th. J. Vermaelen and C. C. P. Wolff

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