Course__PD-LGD-EAD-Modeling__Python

Modeling Probability of Default, Loss Given Default, and Exposure at Default

Models

• PD: Binomial Logistic Regression
• LGD: Beta Regression
• EAD: Beta Regression

Expected loss(EL) and its components: PD, LGD, and EAD

Types of factors for expected loss

• Borrower Specific
• Economic Environment

Established credit risk modeling defines expected loss as PD x LGD x EAD

• PD = Probability of Default
• LGD = Loss Given Default (Min Loss)
• EAD = Exposure at Default (Max Loss)

Example

• Borrower wants to buy house for $500,000
• Lender funds 80% (LTV)
• Loan Amount = $500,000 x .8 = $400,000
• Borrower paid $40,000 so far (outstanding balance = $360,000)
• If borrower defaults EAD will be $360,000
• Assuming imperical evidence that 1 in 4 homeowners default (PD = 1/4 or 25%)
• If borrwer defaults and bank can sell the house for $342,000 immediately then EAD will equal $360,000 - $342,000 = $18,000
• LGD = $18,000 / $360,000 = 5%
• EL = 25% (PD) x 5% (LGD) x $360,000 (EAD) = $4,500

Capital adequacy, regulations, and the Basel II accord

Basel II Accord

• Minimum capital Requirements:
  1. Credit Risk
     • Standardized Approach (SA)
     • Internal Ratings Based (IRB) Approaches
       1. Foundation Internal Ratings Based (F-IRB) Approach
       2. Advanced Internal Ratings Based (A-IRB) Approach
  2. Operational Risk
  3. Market Risk

Basel II approaches: SA, F-IRB, and A-IRB

• SA (PD: External, LGD: External, EAD: External)
  • lending to countries:
    • Risk Weights
      • AAA to AA-: 0%
      • A+ to A-: 20%
      • BBB+ to BBB-: 50%
      • BB+ to B-: 100%
      • Below BB-: 150%
      • Unrated: 100%
  • lending to firms:
    • Risk Weights
      • AAA to AA-: 20%
      • A+ to A-: 50%
      • BBB+ to BB-: 100%
      • Below BB-: 150%
      • Unrated: 100%
  • Retail Risk Weight: %75
  • Retail Risk Weight: %35
• F-IRB (PD: Internal, LGD: External, EAD: External)
• F-IRB (PD: Internal, LGD: Internal, EAD: Internal)