Stress-Testing Probability of Default and Migration Rate with Respect to Basel II Requirements

33 Pages Posted: 21 Mar 2009

See all articles by Peter Miu

Peter Miu

McMaster University - DeGroote School of Business

Bogie Ozdemir

Standard & Poor's

Date Written: October 9, 2008

Abstract

Basel II implementation requires the estimations of probability of default (PD) and migration rate under hypothetical or historically observed stress scenarios. Typically, financial institutions first forecast selected macroeconomic variables under these stress scenarios and then estimate the corresponding stressed PD and migration rates. These stressed parameters are in turn used in estimating the capital requirement and marked-tomarket losses within the capital adequacy assessment framework. In this paper, we demonstrate a practical methodology to estimate both stressed PD and migration rates in a consistent fashion while conditioning on the selected explanatory variables. The estimation methodology allows for the robust use of external data, which is essential in the absence of long enough internal data. The proposed methodology is consistent with the economic model underlying Basel II Pillar 1 risk-weight function, and it is compatible with the financial institutions' existing internal risk rating systems making the implementation and operations cost effective. It also allows for the stress testing at the overall portfolio level as well as that for specific industries. An example of its implementation on the oil and gas sector is provided at the end of the paper. Although the paper is presented within the context of Basel II implementation, the proposed approach can be used as a sound risk management practice to identify, examine and quantify the effect of stress events.

Keywords: Basel II, Stress Testing, Correlation, Probability of Default and Transition,

Suggested Citation

Miu, Peter and Ozdemir, Bogie, Stress-Testing Probability of Default and Migration Rate with Respect to Basel II Requirements (October 9, 2008). Available at SSRN: https://ssrn.com/abstract=1365842 or http://dx.doi.org/10.2139/ssrn.1365842

Peter Miu (Contact Author)

McMaster University - DeGroote School of Business ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada
905-525-9140 ext 23981 (Phone)

Bogie Ozdemir

Standard & Poor's ( email )

130 King Street West
Suite 1100, PO Box 486
Toronto, Ontario M5X 1E5
Canada

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