Gary van Vuuren Riaan de Jongh Tanja Verster

Abstract

The Basel regulatory credit risk rules for expected losses require banks use downturn loss given default (LGD) estimates because the correlation between the probability of default (PD) and LGD is not captured, even though this has been repeatedly demonstrated by empirical research. A model is examined which captures this correlation using empirically-observed default frequencies and simulated LGD and default data of a loan portfolio. The model is tested under various conditions dictated by input parameters. Having established an estimate of the impact on expected losses, it is speculated that the model be calibrated using banks' own loss data to compensate for the omission of correlation dependence. Because the model relies on observed default frequencies, it could be used to adapt in real time, forcing provisions to be dynamically allocated.
Keywords
Probability Of Default; Loss Given Default; Correlation; Economic Capital; Expected Loss

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How to Cite
VAN VUUREN, Gary; DE JONGH, Riaan; VERSTER, Tanja. The Impact Of PD-LGD Correlation On Expected Loss And Economic Capital. International Business & Economics Research Journal (IBER), [S.l.], v. 16, n. 3, p. 157-170, june 2017. ISSN 2157-9393. Available at: <https://www.cluteinstitute.com/ojs/index.php/IBER/article/view/9975>. Date accessed: 19 nov. 2017. doi: https://doi.org/10.19030/iber.v16i3.9975.