A coherent economic framework to model correlations between PD, LGD and EaD, and its applications in EaD modelling and IFRS-9
Abstract
This paper proposes an economic framework recognising EaD as a stochastic variable and capturing the PD–LGD, PD–EaD and LGD–EaD correlations. It explains how these correlations can be estimated from historical data, and how PD, LGD and EaD can then be simulated in determining credit VaR. The framework allows credit losses to be more accurately captured, both in terms of the expected credit losses (ECL under IFRS-9 and CECL) and the unexpected tail events in measuring Credit VaR. The framework quantifies the potential underestimation of the tail risk in Credit VaR and the IFRS-9 ECL if the full correlation structure is not captured. By explicitly modelling EaD in a correlated fashion with PD and LGD, lenders can understand and model the increase in funding requirements during downturns. Application in back-testing IFRS-9 ECL is discussed and supplemented by a numerical example.
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Author's Biography
Peter Miu teaches courses in financial economics and international financial management at the DeGroote School of Business, McMaster University, Canada. His research has been conducted primarily in such areas as credit risk modelling and management, empirical methods and investments. Peter has acted as consultant on such issues as validations of credit risk measures, regulatory capital for issuer risks and stress testing models.
Bogie Ozdemir is a Vice President in Sun Life Financial Group. He is responsible for economic capital and is building out its capabilities for Solvency II/Own Risk and Solvency Assessment (ORSA) and model validation. Bogie was a Vice President in the BMO Financial Group responsible for economic capital, stress testing and Basel analytics, and jointly responsible for the Internal Capital Adequacy Assessment Process (ICAAP). Previously he was a Vice President in S&P’s Risk Solutions, globally responsible for engineering and implementing new solutions and business development. He has co-authored various papers and a book on Basel II implementation.
Citation
Miu, Peter and Ozdemir, Bogie (2023, January 1). A coherent economic framework to model correlations between PD, LGD and EaD, and its applications in EaD modelling and IFRS-9. In the Journal of Risk Management in Financial Institutions, Volume 16, Issue 1. https://doi.org/10.69554/QCVI3102.
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