Cyclical adjustment of point-in-time PD

S Ingolfsson () and B T Elvarsson
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S Ingolfsson: Riskmanagement Ltd.
B T Elvarsson: Íslandsbanki, University of Iceland

Journal of the Operational Research Society, 2010, vol. 61, issue 3, 374-380

Abstract: Abstract Banking regulation stipulates that to calculate minimum capital requirements a long-term average of annual default probability (PD) should be used. Typically, logistic regression is applied with a 12-month sample period to obtain retail PD estimates. Thus the output will reflect the default rate in the sample, and not the long-term average. The ensuing calibration problem is addressed in the paper by a ‘variable scalar methodology’, based on an actual application in a commercial bank. Using quarterly intra-bank loss data over 15 years, a state-space model of the credit cycle is estimated by a Kalman filter, resulting in a structural decomposition of the credit cycle. This yields an adjustment factor for each point in the cycle for each of two client segments. The regulatory compliance aspects of such a framework, as well as some practical issues are presented and discussed.

Keywords: banking; risk; capital budgeting; time series; forecasting (search for similar items in EconPapers)
Date: 2010
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Citations: View citations in EconPapers (1)

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DOI: 10.1057/jors.2009.136

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