Default risk is the probability of the event of default. Several events qualify as default, which we review. Migrations are either deteriorations or improvements of the credit standing of obligors, which translate, respectively, into higher or lower default probabilities. For default events, losses are readily observable. For migrations, the valuation of risk necessitates a mark-to-market […]
The traditional credit culture stipulates that lending is primarily dependent on the credit standing of borrowers, not on covenants or guarantees. The rationale behind this prudent rule is that there is always a residual, small or significant, risk whatever the guarantees. In addition, the credit standing of the borrower ultimately makes the loan perform or […]
Another situation where credit risk measurement raises technical and specific difficulties is structured finance. Many structured finance transactions use Special Purpose Vehicles (SPVs). As their name indicates, these are dedicated entities to a special operation. SPVs serve in numerous structured transactions: • Securitizations. • Project finance.
Ratings rank the credit standing of debt issues using coded letters for the ratings from agencies. Ranks are ordinal numbers, not absolute values of the level of risk, by contrast with default probabilities whose value quantifies the likelihood of default over a given horizon. Internal ratings refer to ratings assigned by banks to their borrowers […]
The main, or global, rating agencies are Moodys, Standard & Poors (S&P) and Fitch. Ratings are assessments of the credit standing of a debt issue, materialized by coded letters (such as Aaa, Aa, etc.) that serve essentially the needs of investors to have a third party view on the credit risk of debt. In addition, […]
Internal rating systems are not public and are customized to each banks needs. There is a strong tendency towards harmonization due to the new regulations putting the rating system in a central position for evaluating capital requirements. Since capital requirements affect pricing, the banking industry needs common benchmarks. Banks have exposure to all sorts of […]
Rating criteria include both qualitative assessment of the counterpartys credit standing plus quantitative variables, most of them being financial variables. Rating a corporate entity will always involve qualitative and judgmental components, simply because there are too many factors that influence the situation of a corporate and of a financial entity. What follows cannot be comprehensive, […]
The IRB approach to capital requirements of the New Basel Accord makes the internal ratings a critical building block of the credit risk management within banks. Banks adopting the standardized approach rely only on external ratings, plus the uniform 100% weight for all unrated entities. Since the majority of bank transactions are usually with unrated […]
The external ratings map to yearly and cumulated default rates, as shown below. Calculations of default rates refer to numbers of firms or are value weighted by size of defaulted issues. When calculating a default rate, it is necessary to refer to a specific number of surviving firms at the beginning of the period. The […]
Default rates are unstable when time passes. The volatility of yearly historical default rates is the standard deviation of observed time series. The volatility increases with the level of default rate, when the rating decreases. Historical volatilities are available from rating agencies for default rates observed across varying horizons. If the volatility is high, the […]
