A Structural Approach to Assessing the Credit Risk of Hong Kong's Corporate Sector

Abstract

Given the close relationship between corporate vulnerabilities and the occurrence of banking and financial crises, regulators need to adopt a financial stability monitoring and surveillance framework which includes the assessment of the credit risk of the corporate sector. This paper illustrates how to assess the default risk of the non-financial corporate sector in Hong Kong by constructing an aggregate market indicator of default probabilities (PDs) using a structural approach (i.e. the Merton model). Rather than relying solely on accounting data, the Merton model quantifies the default risk of the corporate sector as well as credit conditions of different industry sectors using up-to-date market-based information such as equity prices. The study shows that the aggregate PDs derived from the Merton approach reflect the corporate default risk arising from economic shocks. The industry-specific PDs reveal areas of potential weaknesses in different industry sectors. Overall, the PD has proven to be an effective monitoring tool to gauge vulnerability in the corporate sector.

Keywords: Credit risk, Default probability, Structural model

JEL Classification: G12; G33