Basel Requirement of Downturn Lgd: Modeling and Estimating Pd & Lgd Correlations

Journal of Credit Risk, 2006

Posted: 13 Jun 2006

See all articles by Peter Miu

Peter Miu

McMaster University - DeGroote School of Business

Bogie Ozdemir

Standard & Poor's

Abstract

Basel II requires that banks use downturn loss given default (LGD) estimates in regulatory capital calculations, citing the fact that the probability of default (PD) and LGD correlations are not captured. We show that the lack of correlation can be taken care of by incorporating certain degree of conservatism in cyclical LGD in a point-in-time (PIT) framework. We examine a model which can capture the PD and LGD correlation in its entirety, differentiating the different components of correlations in question. Using historical LGD and default data of a loan portfolio, we calibrate our model and, through the simulation of economic capital, we show the mean LGD needs to be increased by about 35% to 41% in order to compensate for the lack of correlations. Our hope is to provide a framework that the banks can use based on their internal data to estimate and justify their LGD choices for different portfolios. Although the paper is presented within the context of Basel II, the applications could be much wider including structured finance, credit derivatives, economic capital and portfolio modeling in general, where PD and LGD correlations need to be estimated and modeled.

Keywords: Basel II, correlation, probability of default, downturn loss given default, economic capital, Point-in-Time, Through-the-Cycle, credit risk models, calibrations, simulations

JEL Classification: C13, C15, G21

Suggested Citation

Miu, Peter and Ozdemir, Bogie, Basel Requirement of Downturn Lgd: Modeling and Estimating Pd & Lgd Correlations. Journal of Credit Risk, 2006, Available at SSRN: https://ssrn.com/abstract=907047

Peter Miu (Contact Author)

McMaster University - DeGroote School of Business ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada
905-525-9140 ext 23981 (Phone)

Bogie Ozdemir

Standard & Poor's ( email )

130 King Street West
Suite 1100, PO Box 486
Toronto, Ontario M5X 1E5
Canada

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