CONTEMPORARY CREDIT

RISK MODELS

Tilburg University
Faculty of Economics and Business Administration
Department of Finance
Thesis supervisor: Muhammad Ather Elahi
Thesis author: Dmitrii Izgurskii
ANR: 570544
URL electronic version: http://homepage.uvt.nl/~s570544/thesis.pdf
June 20th, 2008
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Index

1. Introduction 3

2. Building blocks of credit risk 3

2.1. Default Risk 4
2.2. Concentration Risk 5
2.3 Downgrade Risk 5
2.4 Spread Risk 5

3. Credit risk measurement 6

4. History of credit risk measurement 7

5. Credit-rating agencies 8

6. The CreditRisk+ model 9

7. The CreditMetricsTM model 10

8. KMV Portfolio Manager 11

9. McKinsey’s CreditPortfolioView 13

10. Summary and implications of the models 14

10.1. Summary of models’ characteristics 14
10.2. Ratings of credit-rating agencies 15
10.3. Survey at major global banks 17
10.4. Backtesting the models 18

11. Conclusion 18

Works Cited 20

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1. Introduction

The credit quality problems of the last two-and-half decades posed a challenge for the
financial institutions (FIs) to say the least. Loans that are not or partially repaid drain FIs
working capital very quickly, resulting in lower profits and in worst case a bankruptcy of the FI
itself. The credit quality problems of 1980s were characterized by less developed countries not
being able to repay loans to commercial banks (FDIC, Saunders and Cornett). The 1990s
brought about deteriorating commercials real estate loans, followed by consumers’
disproportionate failure on car loans and credit card payments. The new millennium saw
numerous failures of technology companies, with the two biggest being Enron and WorldCom.
In addition, FIs all over the world saw a rapid growth in trading and development of derivatives.
These financial derivatives, most often in the form of options and swaps, created additional
source of credit risk to an FI (Saunders and Cornett). Quantification of credit risk inherent in
these derivatives is complex and requires sophisticated quantitative tools. These macroeconomic
developments stressed the industry’s prevailing credit risk management methods to the fullest
and were key driving forces behind the developments of latest credit risk models (Wolf and
Vogel 13). This paper will describe the latest credit risk models (CRMs) widely used in the
financial industry for managing credit portfolios. In addition we will determine which model is
suited for what conditions.

2. Building blocks of credit risk

The majority of literature defines credit risk the risk of the obligor not being able to fulfil
the contractually promised payment, the so-called state of default. In this state the value of the
loan made to the firm in default decreases, since payments, on which this value depends, are
missed (Saunders and Cornett 300). Understandingly, credit risk is often assumed to be
represented by default risk. However, the true credit risk would be undervalued if we only
adhere to that definition. This is because in addition to default risk, other non-market risks also
contribute to the uncertainty of the bonds’ and loans’ value. Excluding them would only give a
partial measure of credit risk. The risks comprising the credit risk, as managed and measured by
FIs, are discussed below.

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2.1. Default risk

As mentioned earlier, default risk is the risk that the borrower fails to fulfil its contractual
obligations. The presence of default risk implies that the lender will receive on average less than
what is stated in the loan contract. Formally this can be stated as

ROA = [1 − P(default)] × (1 + r ) − 1 , (1)

where ROA signifies return on assets that the lender transfers to the borrower and r is the
contractual interest rate (Saunders and Cornett 300). This equation plays key role in pricing
loans. When a borrower inquires for the pries of loans, i.e. interest rate r, a lender estimates this
particular borrower’s probability of default and the desired ROA he or she wishes to achieve on
the loan. Using these as independent variables, the lender then calculates the loan’s interest rate
and communicates it to the borrower. Consider for example a lender facing a firm wanting to
borrow funds. The internal credit rating department estimates this borrower’s probability of
default (PD) to be 8 percent. Additionally, other projects with attractive ROAs are available to
the lender, and so it requires a minimum of 13 percent ROA on this particular loan. Using (1),
the interest rate quoted to this particular borrower is 22.83%, as calculated below.

0.13 = 0.92(1 + r ) − 1
1.13
r= − 1 = 0.2283
0.92

There is one caveat when pricing a loan using this method: probability of default is often
hard to estimate accurately because not all required information is available. Default occurs
when a firm has not enough funds to repay its debt obligation. By monitoring firm’s assets and
liabilities, a clearer picture arises of the firm’s financial situation. However, accounting
statements containing this information are released on quarterly basis or even less often. By the
time the information is extracted from these statements it is already obsolete and gives just a
snapshot of firm’s historical value.
When pricing a loan the lender transfers the default risk to the borrower through loan
prices and it will always want to err on the upside of the PD estimate, which implies higher
interest rates to the borrower. However, the borrower wishes to get finances as cheap as possible,
so it is also in her interest to have its PD estimated not higher than it actually is. The borrower

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tries to achieve this by providing additional information about its finances and operations to the
lender’s credit analysts. Additionally, it can acquire a rating from S&P’s if it deems it as a good
investment in a sense that the total cost of funds and the rating service will be less than if the
firm borrowed funds while being unrated.

2.2. Concentration risk

Concentration risk refers to the risk of having solvency-threatening losses due to loans
being unevenly distributed between counterparties, or concentrated in a specific region or
industry sector. The concentration of loans to individual counterparties is coined granularity,
whereas concentration of loans in specific industry and/or region is referred to as sectoral
concentration (Deutsche Bundesbank 35-37). The correlations between borrowers under
different macroeconomic scenarios determine the intensity of the losses due to concentration
risk. In a 2004 study by the Basel Committee, it was found that 9 out of 13 major financial
institution collapses were caused by exposure to excessive levels of concentration risk. (York
57). This might explain why the focus of contemporary CRMs is predominantly on
concentration risk of a credit portfolio, measurement of which is cumbersome since subjective
estimates based on asset correlations need to be made. Once the concentration risk for a
portfolio is determined with the help of a CRM, one can neutralize it by diversifying the credit
portfolio.

2.3. Downgrade risk

Another type of risk is the downgrade risk, a risk that a loan’s or portfolio’s present value
(PV) drops as an effect of an increased PD. A rise in the PV should not be considered as a risk
since it increases one’s utility, to which rational agents will never object, unless the portfolio
contains credit derivatives whose value is inversely correlated with the underlying. To hedge
against downgrade risk a corporation needs to hold a position in derivatives whose value moves
up as the value of bonds drops.

2.4. Spread risk

Lastly, an FI might be subject to spread risk, also known as basis or margin risk. This is
the risk of being exposed to a spread in interest rates. It usually occurs when an FI tries to
neutralize the uncertain movements in interest rates by letting the loan rate float with some other
rate it is based on, like prime rate, while financing the loan with another floating rate, like
LIBOR.

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For example, consider a bank that made such a commitment while present prime and
LIBOR rates are 8 and 4 percent respectively. This bank will then realize a 4 percent gross profit
on the next horizon by receiving 8 percent and paying back 4 percent. However, at the second
and subsequent horizons, the spread between these two rates might be different from the initial 4
percent. This uncertainty is the spread risk (Riskglossary.com, Saunders and Cornett 366).
Not unexpectedly, there is some argument about whether spread risk is market risk or
credit risk. If the financing of a FI is obtained in the market, then movements in these rates are
coined as market risk. On the other hand, movements in the debt values represent credit risk.

3. Credit risk measurement

Financial institutions measure credit risk for several reasons. First, by quantifying
counterparty’s credit risk in monetary terms, the lender can price a loan accordingly.
Commercial and Industrial loan interest rates are often quoted in two parts. The first part is the
base lending rate, often being set to equal the LIBOR or prime lending rate. The second part,
coined the credit risk premium or margin, is the rate that the bank demands for a particular
borrower. For example, a start-up company might pay current LIBOR of say 8% and 5% credit
risk premium on a one-year $1m loan, while an AAA-rated corporation is charged 8% LIBOR
and 0.5% credit risk premium for the same loan.
The second reason is that FIs often want to limit their potential loss exposure to a
particular borrower or group of borrowers possessing some characteristic, the so-called practice
of credit portfolio diversification. A recent example is that of Japanese FIs incurring large losses
on their over-concentrated investments is real estate in Asia (Saunders, Cornett 2006). Arguably,
this could have been prevented by applying principles of diversification.
Lastly, regulatory powers require banks to maintain certain levels of capital to ensure
stability in banks operations. The required capital designated to cover exposure to credit risk is
generally lower than that assigned by standardized set of rules. The Bank for International
Settlements (BIS) tries to address this issue through its publications of proposed regulatory rules.
The BIS is an institution that acts as the central bank for central banks of member
countries. Its members, mostly commercial banks, are advised to maintain certain levels capital
depending the bank’s assets. The purpose of this capital adequacy policy is to ensure stable
financial environment. The required minimum levels of capital are often given as the ratio of the
total exposure to certain market risk. As of 1998, BIS capital requirements could be calculated

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in two ways, either by using the BIS Standardized Framework or by using own internal models
of risk assessment. Although internal models provide greater degree of freedom they are still
subject to strict regulatory supervision (Saunders and Cornett 575-601). Additionally, in 2001
the BIS issued regulatory document which specified two methods for calculation of capital
requirements for exposures to credit risk. The choice was between the Standardized Approach
and the strictly audited Internal Rating-Based (IBR) approach. The IBR approach allows FIs to
use their own credit risk assessment tools to estimate capital requirements (Saunders and Cornett
579, Basel Committee on Banking Supervision, 31 May 2001).

4. History of credit risk measurement

Up to the late 1970s the credit risk assessment was analyzed using predominantly
qualitative models. Qualitative models, also called expert systems, rely on FI’s experts to use
their skills and insights to make a decision whether to grant credit or what the loan price should
be. The focal points of the analysis are borrower’s reputation, capital structure, volatility of
earnings and collateral.
For today’s risk management qualitative models prove to be unsuitable. Assessing the risk
of a single obligor takes a lot of experts’ time and it would be impractical to assess all banks
credit transactions. Exceptions are made when the counterparty represent significantly large
exposure, so that the expensive analysts time is justified in monetary terms. J.P. Morgan and
U.S. banks in general still consider that additional expert evaluation will outperform existing
quantitative models (J.P. Morgan I, Federal Reserve 898). In addition, the sophistication of
present credit instruments demands assessment methods based on numerical analysis. Hence the
banks’ shift towards quantitative models presented opportunities to save costly time and offer
objective evaluation of credit instruments.
For the above mentioned reasons, quantitative models are considered the better alternative
to qualitative models due to their fast processing time and objective predictions. Moreover, these
models incorporate widely recognized modern financial theory and widely available financial
data.
The latest CRMs focus on predicting the distribution of credit losses through either Monte
Carlo simulations or analytical methods. Additionally, besides default risk, the new breed CRMs
also weigh in concentration risk, downgrade risk and spread risk in the overall assessment result.
The existence of the quantitative CRMs is predominantly the result of technological

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developments and improved financial data availability and regulations (Wolf and Vogel 13-17,
Altman 190-96).

5. Credit-rating agencies

Credit-rating agencies are in effect outsourced credit-risk assessment analysts. The costs
of credit risk assessment on a bond issue are incurred by the borrower of the funds instead of the
lender. Bond rating agencies, most notable are Moody’s KMV, Fitch and Standard and Poor’s,
offer a wide variety of fee-based credit-ratings services to corporate and government clientele.
One of these services is when a debt issuer acquires a credit-rating for it’s newly issued debt,
because he or she estimates that the monetary gain from it is greater than cost of acquiring such
a rating. The rating-agencies use proprietary quantitative credit risk models in conjunction with
large databases of financial and management data to assign a rating to a bond. Additionally, the
agencies’ financial experts review the ratings using qualitative analysis techniques (Standard
and Poor’s).
Standard and Poor’s, the current market leader in global credit ratings (Standard and
Poor’s June 2008), uses seven categories to rate bonds based on their default probability, with
each rating representing a range of PDs. The AAA category represents debt that is least probable
to default and CCC category being the most likely to default. Exhibit 1 shows a transition matrix.
For example, bonds graded AAA had a beginning-of-the-year PD of 0.00% to default at year-
end. In contrast, junk-bonds, rated CCC, had a PD of 14.55% to default in at the horizon. The
last column of the table, titled NR lists the probability of a bond’s rating to be withdrawn.

2007 Global Transition Rates (%)

From/to AAA AA A BBB BB B CCC D NR
AAA 95.60 2.20 0.00 0.00 0.00 0.00 0.00 0.00 2.20

AA 0.60 91.37 3.21 0.00 0.00 0.00 0.00 0.00 4.82

A 0.00 2.90 86.6 2.75 0.22 0.30 0.07 0.00 7.50

BBB 0.00 0.26 3.81 83.69 2.70 0.66 0.07 0.00 8.81

BB 0.00 0.00 0.00 6.72 75.26 6.44 0.09 0.19 11.3

B 0.00 0.00 0.00 0.08 7.43 75.0 2.56 0.24 14.3

CCC 0.00 0.00 0.00 0.00 0.00 20.0 45.45 14.5 20.0

Exhibit 1. Transition rates of rated bonds for the year 2007 (Source: Standard and Poor’s, 2007).

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6. The CreditRisk+ model

The CreditRisk+ model was published by Credit Suisse Financial Products in 1997. It
belongs to the default-only type of models since changes in credit quality, as measured by credit
ratings of S&P’s, are not modeled. The model estimates distribution of credit-portfolio losses
with the purpose of using it to calculate economic capital. Economic capital are funds used to
cover unexpected losses up to some degree, say 1 percent; meaning that 1 percent of the time the
losses will deplete all economic capital. The nature of assumptions that the model makes about
the inputs, makes it best suitable for analysis of credit-portfolios comprising many small loans,
like mortgages, consumer loans and small business loans (Saunders and Cornett 339-341).
The LGD denotes the rate of one unit of currency that is recovered given that the obligor is
in default. A specific obligor’s LGD will largely depend on how efficient the assets of the
defaulted firm will be transferred to the creditor, the liquidity of the assets and tangibility of the
assets. A loan to a firm with relatively large share of intangible and illiquid assets, for example
stored in research and development, will have relatively high LGD and is therefore riskier.
Estimates of LGDs stem from different sources, like FI’s own experts or credit rating agencies.
Although the model assumes initially that LGDs are constant, this conjecture can be relaxed by
allowing LGDs to follow some distribution. This relaxation will result in multiple values of
LGD for a single loan, just like in the real world. Multiple LGD values lead to improved
predictions about portfolio’s PDF, but only if the distribution underlying the LGD is estimated
accurately (Saunders Cornett 339-41).
The default rate of a single loan is assumed to be random and uncorrelated to other rates in
the portfolio. As a result, the defaults in the credit-portfolio can be approximated with the
Poisson distribution, which is a key factor in determining the allocation of economic capital
(Credit Suisse First Boston).
CreditRisk+ is very fast in terms of computing speed due to its analytical estimation
methods. Additional advantage is that the model does not suffer from ambiguity -- a particular
set of input values will always result in same portfolio loss distribution.
As the size of credit-portfolio grows, the computation speed decreases rapidly up to the
point that the model is on par with a simulation model. Another consequence of the analytical
approach is that estimation process of certain statistics requires non-analytical techniques that
are out of CreditRisk+’s scope (Saunders and Cornett 339-41).

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7. The CreditMetricsTM model

The CreditMetrics model was made public in the form of a document titled
“CreditMetrics™ - technical document”, released by J.P. Morgan in April 1997. The bank’s
reasons for the publication were (a) to provide a common benchmark model of credit risk; (b) to
increase transparency in credit risk management; (c) to give its clients a tool for evaluation of
the bank’s credit risk advice. (J.P. Morgan I).
CreditMetrics is a quantitative model that enables a financial practitioner to calculate
credit Value-at-Risk based on portfolio’s loss distribution at horizon. The only required input is
historical data. Other possible inputs, like macroeconomic variables, are ignored and therefore
the model belongs to the type of unconditional models in which the transition matrix does not
depend on current state of the economy. The credit Value-at-Risk calculation process starts with
inference of debt market-values from debt’s quality rating assigned by credit-rating agency or
internal ratings department. In the next step, the portfolio-loss distribution is constructed from
individual debt market-values at horizon and their correlations. Once portfolio-loss distribution
is determined, the model computes Value-at-Risk figure. This figure is key factor in assignment
of economic capital and/or regulatory capital to the specific portfolio.
CreditMetrics accounts for three of the four risks that comprise credit risk. Specifically,
derivation of concentration risk is possible from the correlation matrix of credit rating
movements. Such table specifies for every obligor in the portfolio the probability of a credit
rating movement given that a movement in credit rating of other obligor has occurred.
Downgrade and default risks figures are found in transition matrices, which simply list the
probability of movement to a different rating class in the next period.
The model’s scope are traditional credit instruments like fixed-income securities, loans,
forwards and swaps and other contracts because of its assumption that credit facilities are based
on deterministic, i.e. fixed, interest rate. Credit risk measurement of derivatives based on
floating interest rates is beyond scope of the model.
Most of the fixed income instruments are traded in the OTC market and so their value and
volatility cannot be observed directly as with exchange traded instruments. In order to calculate
credit-Value-at-Risk for these bonds/loans, their value and volatility must be estimated from
their credit rating, the rating transition matrix, LGD and credit spreads. However, the more
estimations required, the greater the chance that the outcome of the model will be inaccurate.

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8. KMV Portfolio Manager

The KMV Credit Portfolio model of credit risk assessment was released in 1993. This
credit risk tool estimates the asset-value of a firm using the Merton’s option-valuation approach.
The results were then transformed into the so-called Distance-to-Default (DtD) rating which is
used to calculate the model’s main output, the Expected Default Frequency (EDF). Instead of
using transition matrices from other vendors, the model uses the EDFs to develop its own
transition matrix. The loss correlations between firms are calculated based on the common risk
factors of firms’ assets. Then using the transition matrix and the correlations, the KMV model is
able to estimate the distribution of portfolio losses. As seen in previous models, the economic
and regulatory capitals are derived from this distribution (Wolf and Vogel 13-17).
Unfortunately the information about firm’s liabilities is not always as transparent as is
desired. The trading of corporate debt happens for the most part in the OTC market, which is not
transparent to the public. Therefore, we cannot derive the firm’s value and volatility from these
unobservable figures. To bypass this issue, the KMV model utilizes Robert Merton’s option-
valuation model to price firm’s liabilities. In order to employ it, several simplifying assumptions
about firm’s capital structure need to be made. Specifically, the capital structure of the firm is
composed of equity, short-term debt, long-term debt (assumed to be a perpetuity) and
convertible preferred shares. The value and volatility of equity are functions of asset’s value,
asset’s volatility, the leverage ratio of the firm, average coupon paid on long-term debt and the
risk free rate. The value of equity is directly observable in the stock market and so the asset
value can be found by rearranging the function. From the time series of asset value we then
derive the asset volatility. According to the Merton’s option-valuation framework, default
occurs when assets value falls below the value of firm’s liabilities. However, in practice, KMV
has observed different thresholds of asset value below which firms default. This threshold lies
between the value of short-term debt and the value of total liabilities. In order to produce more
accurate estimate of EDF the DtD ranking is calculated first. In effect, DtD tells us how many
standard deviations (volatilities) a firm is away from default implying that for larger DtD the
firm is less likely to default. The figure below helps to visualize the DtD concept.

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Exhibit 2. The Distance-to-Default concept (Source: Crouhy et al. 2000)

In the last phase, the model maps DtDs to the EDFs. This is by looking into historical data
– Moody’s KMV has world’s largest database for that purpose – and finding what percentage of
firms with a specific DtD ranking did default. The EDF measure accounts only for default risk
component within the encompassing credit risk. In case of large portfolio of credit instruments, a
bank wants to also assess the concentration risk. In order to do that, it needs to estimate the
correlations of these credit instruments comprising the portfolio. KMV Credit Portfolio relies on
multi-factor model of asset returns to find correlations between the assets. Using correlations
based on historical asset prices is impractical when dealing with large portfolios. A portfolio
consisting of N debt instruments would require estimation of N(N-1)/2 correlations. If N is 1000
then we need to estimate 499500 correlations. In addition, the correlations might be inaccurate
due to sampling errors in historical asset prices. The multi-factor model neutralizes these
imbalances. This model assumes two categories of risk factors that drive asset returns:
systematic factors and non-systematic factors. Asset correlations are result of systematic risk
factors inherent in all bonds comprising the portfolio. Global economic, regional and industry-
sector factors are considered to be common factors. In a model of asset returns with only two
common factors, the correlation between assets returns in a portfolio would require us to
estimate KN+K(K–1)/2 parameters. Here, N stands for number of assets in the portfolio and K
stands for number of common factors. Again, in case of 2 common factors and 1000 bonds,

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estimation of 2003 parameters is needed compared to 499500 parameters, had we used historical
correlations method. Using the correlation numbers in calculation of asset returns, and
subsequently the distribution of future portfolio loss, ensures that concentration risk is accounted
for.
Unlike CreditMetrics model, the Credit Portfolio does not simulate the values of a loan
portfolio at credit horizon. Instead an inverse gaussian distribution is derived which represents
the future possible losses of the portfolio. But for that to be the case we have to assume that a
portfolio is well deversified. Then it can be shown that its loss (represented by random variable
L) at time t (assumed to be less than maturity T) equals the difference between its future value in
a world with no defaults and its future value in world with defaults. Formally:

L = Vt , ND − Vt

The distribution of L is approximated by inverse Gaussian distribution which is skewed,

leptokurtic and non-normal. Once this distribution is established, an FI is able to estimate the
required capital cushion necessary to absorb an α-% worst case loss. The following example
illustrates how the assumption about the distribution of portfolio loss affects the economic
capital. Assume many obligors with the same loss correlations of 0.4 and EDFs of 1%. Capital
cushion against 1% worst case loss would require us to hold 4.5 times the volatility of the
portfolio loss. Had we used standard normal distribution as the approximation of the distribution
of portfolio loss, than already 2.3 times the portfolio loss volatility would suffice.

9. McKinsey’s CreditPortfolioView

The CreditPortfolioView model is based on research papers of Tom Wilson published in

1987 and 1997. At the time of the publication of second paper he was Chief Risk Officer at
McKinsey & Company and it is this company that employed the model. However at the present
time it seems that McKinsey no longer supports the model.
CreditPortfolioView assumes that default and migration probabilities are influenced by the
macroeconomic factors. The main drivers behind economy’s health are the GDP growth rate,
interest rates, unemployment rate, foreign exchange rate, government expenditures, and savings
rate. The model takes a starting-point-matrix based on Moody’s KMV or S&P’s historical data.

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Next, taking the prevailing macroeconomic conditions as inputs, the model utilizes Monte Carlo
simulation methods to output the conditional transition matrix. This matrix shows the default
and migration probabilities of firms belonging to a particular industry sector to which earlier
defined macroeconomic variables apply. Subsequently the conditional transition matrices can be
used to either price a loan or calculate portfolio’s credit-VaR (Crouhy et al.).
As Crouhy et al. point out (2000), the calibration process (the reverse of linear regression)
requires that the initial transition matrix with the unconditional probabilities is very closely
aligned with the real world; otherwise estimates based on it will be too inaccurate to be
meaningful. Furthermore they point out that older and simpler Bayesian model in conjunction
with analysts expertise might perform just as good.

10. Summary and implications of the models

10.1. Summary of models’ characteristics

Exhibit 3 provides a quick reference for the models’ main characteristics

KMV Portfolio CreditMetrics CreditRisk+ CreditPortfolioView

Manager
Risk driver Asset values Asset values Expected default Macroeconomic
rates factors
Definition of risk Default losses Market-value change Default losses Market-value change

Credit events Continuous default Downgrade/default Default Downgrade/default

probabilities
Transition EDF (based on asset- Constant, historical N/A Macroeconomic
probabilities value) factors
Loss correlations Asset-return factors Equity-return factors Conditional on Conditional on
common risk macroeconomic
factors factors
Recovery rates Random distribution Random distribution Constant Historical
(equal to 1-LGD) distribution
Output Analytical/simulation Simulation/analytical Analytical Simulation
computation
method

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Exhibit 3. Main characteristics of the 4 main models (Source: Wolf and Vogel)

CreditRisk+, as seen in the table, does not use transition probabilities. This implies that the
changes in value due to an obligor’s deteriorating credit quality will not be used in the model.
Hence, this model less suitable for corporate bonds which often have fluctuating probabilities of
default, but not an actual default, causing their values to fluctuate. Portfolios that this model is
suitable for are rather small and consist of identical loans, often made to retail consumers and
small firms that are not publicly traded.
In general, recovery rates modelled by random distribution, rather than being constant, offer a
better approximation of the real world. Historical recovery rates are better than constant rates,
but still worse than random distribution recovery rates, because of the probability that the actual
distribution underlying these rates has changed. Although KMV and CreditMetrics models make
use of random distribution to model recovery rates, it still should be remembered that these need
to be defined correctly for any output to have a meaningful result. The models are highly
sensitive to even slight changes in numerical data and so any misspecification results in erratic
numbers.
The two models from the previous paragraph also have the best of both worlds in output
generation. Analytical method is accurate and fast for small portfolios, but cannot always be
applied. As an alternative, Monte Carlo simulation methods offer a means for output calculation
especially in case of large portfolios and random input data.
One of the major strengths of KMV model is that it is based on continuous credit events.
Daily updates of credit portfolio risks are possible due to availability of equity price data and
this process is integrated in KMV. The acquisition of KMV by Moody’s, a firm specialized in
collecting market data and rating firms, certainly made that process a lot easier.

10.2. Credit-VaR estimation process with CreditRisk+

As mentioned earlier, CreditRisk+ can readily be used with small portfolios of small
loans. Consider the following example, based on the example in Saunders and Cornett (339-
41). Assume that FI’s portfolio consists of 100 loans of $10,000, for a total of $1m. The EDF
and LGD are estimated at 2.5% and 50% respectively, for each loan in the portfolio. Then the
Poisson distribution is used to generate frequency distribution of defaults for the 100 loans
portfolio.
The distribution of portfolio losses is easily derived from the distribution of defaults.
Each default represents a loss of (1 – LGD) times the loan value of $10,000 which equals

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$5,000. Then the number of defaults is simply multiplied by loss per default. This produces
the CreditRisk+ model’s main output, the frequency distribution of portfolio losses seen in
exhibit 4.

Ehibit 4. Distribution of portfolio loss (Based on Saunders and Cornett 341)

Now that the FI has the required numbers, it can calculate the required economic capital
to hold in order to protect itself from unexpected losses. The bank expects to lose on average
$10,000 and this amount in already incorporated in loan prices and loan loss provisions.
Additionally, the FI itself decides or is given regulatory mandate to insure itself against some
very unlikely unexpected losses. If the FI is required to be able to cover losses in 95% of all
possible cases then it must hold so much economic capital that when a loss of probability of 5%
occurs, the economic capital covers that loss precisely up to a dollar. On the other hand, a 4%
worst-case scenario loss could not be covered with the economic capital. In this example, a 5%
worst-case loss equals roughly $25,000 which corresponds to the default of 5 loans in the 100-
loans portfolio. Since the bank already holds $10,000 in required capital to cover expected
losses, it only needs to account for the difference between the amount needed to cover
unexpected loss and amount needed to cover expected loss, which is $15,000. Economic capital
in fact is nothing more than the cut-off point with the desired worst-case scenario probability
being the are to the right of that point. See exhibit 5 below.

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Exhibit 5. Economic capital is the cut-off point at 99th percentile (Source: CSFB 24)

10.2. Ratings of credit-rating agencies

For the sake of accuracy of the predictions it is best not to use transition matrices of credit
rating agencies because their ratings are not continuous but rather discrete. By the time a certain
rating is used, the state of the firm it belongs to has already changed, and a new estimate should
be made. The model that suffers the most from is CreditMetrics, precisely for the fact that it uses
transition matrices of credit rating agencies. The KMV Portfolio Manager on the other hand
avoids this issue by constructing its own, EDF based transition matrix. The EDFs are updated
continuously as new stock price and accounting data flows in. For portfolios of exchange listed
credit instruments, the KMV Portfolio Manager clearly is superior to any other model.

10.3. Survey at major global banks

Smithson et al. provide a report (2002) of international survey amongst 41 global banks
about their practices of credit portfolio management. Most notable points are that the largest
exposures in the credit portfolios of the surveyed banks are attributed to large and middle-
market corporations and banks. The instruments behind these exposures are mainly undrawn
lines of credit, bilateral bank loans and syndicated bank loans. Since the obligors of these credit

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facilities are very often listed on stock exchanges, one would expect that a credit risk model that
incorporates public equity and bond prices would be a dominant contender. As it shows, this is
case. The KMV Portfolio Manager is used at 69% of banks as the primary model of formal
credit portfolio management. It is followed by CreditMetrics based CreditManager, which
accounts for 20%. 17 percent of respondents use internally developed CRMs and only 6 percent
manage the portfolio with a macro-factor model, perhaps such as CreditPortfolioView. The
results need to be interpreted carefully, because they only represent global trend in portfolio
management. Nevertheless, it seems that CreditPortfolioView has lost the battle in the credit risk
management arena to a degree that almost all public information regarding it, including the main
technical document, is nowhere to be found.

10.4. Backtesting the models

Backtesting refers to the practice of using historical data as inputs into the model and
evaluate its ability to predict the defaults – which are of course already known. If needed, the
model’s weights for different factors can then be adjusted so that it predicts the defaults with
greater accuracy.
Backtesting requires large samples of default data in order to conclude with sound
statistical proof that a CRM is indeed useful in default prediction. However, the majority of
credit instruments that the CRMs are intended for are either illiquid or their prices are hidden
from the public. As a consequence, the price data on these instruments is sparse, forcing a
researcher to engage in small-sample-statistics, a highly unreliable practice. The large
proprietary Credit Research DatabaseTM of Moody’s KMV surpasses this hurdle and offers
opportunities significant backtesting research that benefits their model (Crouhy et al., Lopez
163).

11. Conclusion

In this paper we have studied the four major credit risk models that are used for pricing of
loans and estimation of economic capital. In the near future, when the Basel Committee for
Banking Supervision has seen more evidence on the accuracy of these models, the regulatory
capital will be also determined using these tools. At the present time, data limitations in the form
of sparse financial loan information pose too big of a problem. We have also seen that
CreditRisk+ model suits small portfolios of loans to homogeneous borrowers, especially the

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ones not publicly traded. On the other side, the KMV’s Credit Portfolio has a monopoly on
managing portfolios of highly liquid credit instruments with large exposures. Almost continuous
monitoring of default probabilities and credit-Value-at-Risk is possible due to seamless
integration with the equity price data. The CreditMetrics model is a second-best alternative to
KMV, often producing similar results in terms of credit-VaR. CreditPortfolioView on the other
hand is discontinued by McKinsey consultancy either because its developer, Tom C. Wilson left
the company or simply for the reasons that it produced unsatisfactory results. Strangely, the
academia seems to hold on to this model by citing it in the comparisons with other models. This
paper followed suit, but only in order to give a full description of the spectrum of possible
CRMs. The availability of information on the model gives the impression that it is nowadays
just an archive-filler.

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