A 2-Factor model for inclusion of Voluntary Termination Risk in Automotive Retail Loan Portfolios

Abstract

Under the UK Consumer Act 1974, obligors of Hire Purchase and Conditional Sale contracts are allowed to perform a Voluntary Termination (VT) once certain conditions are met. Upon such an event, lenders recover the underlying assets but are potentially liable to losses upon liquidation of the assets. This poses a challenge from a risk modelling perspective, as these financial products exhibit Credit (default) risk as well as VT risk, and these two events are mutually exclusive. In this paper we propose a modelling framework to account for Credit/Default and VT risk for Retail portfolios, designed as a 2-factor Monte Carlo simulation of loan-level termination events. The paper concludes with numerical and backtesting results from a real-life implementation of such framework in the context of an automotive loan portfolio.

Keywords: Credit Risk, Retail Banking, Retail Risk, VT Risk, Automotive Finance