Reconciling Credit Correlations

Abstract

The credit crisis has created a new impetus for regulators to analyse the framework for determining regulatory capital requirements, in particular the assessment of credit risk will be challenged. Confronted with a lack of default statistics it is common practice by industry practitioners to apply a financial approach, also known as Merton’s model of the firm, and we remark that the latter approach also underpins modern solvency standards such as Basel II and Solvency II.

However, while Merton’s theory is an academic beauty its implementation does not make full use of available default statistics but relies on the concept of so-called asset correlations instead. We study the different estimates used for asset correlations that have been mentioned in the literature and analyse to which extent these estimates are in line with each other, with available default statistics as well as with our own findings.

Our results are in line with the majority of the literature but deviate away from the results reported by some major software providers as well as the Basel II and Solvency II figures. We offer several explanations as an attempt to reconcile the differences and point to several other features that should not be overlooked when building credit portfolio models.

Keywords: Solvency II, Basel II, KMV, MKMV, Asset Correlation, Credit Risk, Economic Capital, VaR