Are you ready to continue our journey? The topic of this week is very interesting.

As seen in lecture 1, credit risk is the risk, which arises from the possibility that our counterparty may default, or that his/her credit quality may deteriorate.

In the Basel framework, a key parameter, which is used to calculate the regulatory capital for credit risk, is the Probability of Default, often indicated with the acronym PD. As seen in lecture 2, this is particularly true under the F-IRB and A-IRB approaches.

Under the F-IRB approach, banks can develop their own empirical/statistical model to assess and estimate the Probability of Default for individual clients (or classes of clients). Obviously they are allowed to use this approach only subject to approval from their local regulators, which also prescribe certain ways of defining the LGD (Loss Given Default) and other parameters required for the computation of the RWA (Risk Weighted Assets). Hence: banks compute their PDs, but they rely on the regulator for the other quantities and formulas.

When using A-IRB, banks are conversely allowed to develop and use their own quantitative models to estimate all the quantities involved in the calculation of the RWA, from the PD to the LGD and the EAD. Hence:banks are “free” to compute all quantities of interest, provided that their model is accepted by the regulator.
In both approaches, capital requirements are then computed as a fixed percentage of the estimated RWA.
In the next weeks, we will see more about all this.

The PD is nothing more than the likelihood of the default of a counterparty over a particular time horizon, a very common one being 1 year.

But…what is technically a default?
The convention is that a debt obligation is said to have defaulted when:

• our counterparty, the obligor, is more than 90 days past due on his/her credit obligation;
• it is considered unlikely that the obligor will repay his/her debt without giving up any pledged collateral.

There are different ways of computing the Probability of Default of a counterparty. Some of these techniques belong to the F-IRB approach, whereas others are classified as A-IRB.
Starting from this week, and for the next three weeks, we will take into account many different instruments for the determination of the PD.
This week we will focus our attention on rating models, in particular under the IRB approach.
Week 5 and 6 will be devoted to default models, including some very important proprietary approaches by Moody’s KMV, Credit Suisse and JP Morgan.

This lecture contains: