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Practitioners’ Corner

Practitioners’ Corner Journal of Financial Econometrics, 2005, Vol. 3, No. 2, 310–313 According to the advanced implementation options of the Basel II accord, finan- cial institutions are explicitly required to assess their credit exposure for each customer and for each credit facility using three measures: the probability of default for each customer, the loss given default, and the exposure of the credit facility at default. Once the three measures are determined, it is then straightfor- ward to compute the minimal capital requirements required by Basel II to hedge the institution’s exposure to credit risk. In this context, the prediction of corporate failure or default is a key ingre- dient of credit risk analysis. However, a good number of models suffer from two shortcomings that compromise the practical objectives of the Basel II accord. The term structure of the probability of bankruptcy is often assumed to be flat. The resulting technical tractability is purchased at the cost of potentially highly mis- leading predictions of bankruptcy rates over time horizons of more than one year. Time-varying factors, some firm specific, such as the distance to default intro- duced in the Black-Scholes-Merton structural model of default probabilities [Black and Scholes (1973)], a firm’s size http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Financial Econometrics Oxford University Press

Practitioners’ Corner

Canopius, Adam
Journal of Financial Econometrics , Volume 3 (2) – Jan 1, 2005
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Publisher
Oxford University Press
Copyright
© The Author 2005. Published by Oxford University Press. All rights reserved. For permissions, please e-mail: journals.permissions@oupjournals.org.
ISSN
1479-8409
eISSN
1479-8417
DOI
10.1093/jjfinec/nbi014
Publisher site
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Abstract

Journal of Financial Econometrics, 2005, Vol. 3, No. 2, 310–313 According to the advanced implementation options of the Basel II accord, finan- cial institutions are explicitly required to assess their credit exposure for each customer and for each credit facility using three measures: the probability of default for each customer, the loss given default, and the exposure of the credit facility at default. Once the three measures are determined, it is then straightfor- ward to compute the minimal capital requirements required by Basel II to hedge the institution’s exposure to credit risk. In this context, the prediction of corporate failure or default is a key ingre- dient of credit risk analysis. However, a good number of models suffer from two shortcomings that compromise the practical objectives of the Basel II accord. The term structure of the probability of bankruptcy is often assumed to be flat. The resulting technical tractability is purchased at the cost of potentially highly mis- leading predictions of bankruptcy rates over time horizons of more than one year. Time-varying factors, some firm specific, such as the distance to default intro- duced in the Black-Scholes-Merton structural model of default probabilities [Black and Scholes (1973)], a firm’s size

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Journal of Financial Econometrics – Oxford University Press

Published: Jan 1, 2005

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