A Two-Factor Model for PD and LGD Correlation

Abstract:     
The paper proposes a two-factor model to capture retail portfolio probability of default (PD) and loss given default (LGD) parameters and in particular their mutual correlation. We argue that the standard one-factor models standing behind the Basel II formula and used by a number of studies cannot capture well the correlation between PD and LGD on a large (asymptotic) portfolio. Parameters of the proposed model are estimated using the Markov Chain Monte Carlo (MCMC) method on a sample of real banking data. The results confirm positive stand-alone PD and LGD correlations and indicate a positive mutual PD x LGD correlation. The estimated Bayesian MCMC distributions of the parameters show that the stand alone correlations are strongly significant with a lower significance of the mutual correlation probably due to a too short observed time period.

Number of Pages in PDF File: 25

Keywords: credit risk, recovery rate, loss given default, correlation, regulatory capital

JEL Classification: G21, G28, C14

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