A Simple and Consistent Credit Risk Model for Basel II/III, IFRS 9 and Stress Testing when Loan Data History is Short

Abstract

In the current regulatory environment, banks are required to quantify credit risk by means of default probabilities, loss rates conditional on default and expected exposures for a number of purposes: Regulatory capital calculation, loan loss provisioning and stress testing. The nature of each credit risk parameter might be different for each application, e.g., forward looking default probabilities are needed for loan loss provisioning while regulatory capital is based on long-term averages. Those different requirements for each purpose create a substantial burden especially for small and medium-sized banks. This article describes a simple framework that allows the consistent calculation of credit risk parameters for all risk applications. It assumes that a bank is using a scorecard based on loan-level data where the data history might only span a couple of years. This data is combined with a macroeconomic model in a suitable way to derive risk parameters compliant with all regulatory requirements.

Keywords: Basel II, IFRS 9, Stress Testing, PD, LGD, EAD, Credit Risk

JEL Classification: G21