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Accounting for PD-LGD dependency: A tractable extension to the Basel ASRF framework

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  • Barbagli, Matteo
  • Vrins, Frédéric

Abstract

We extend the asymptotic single risk factor (ASRF) model used in the Basel regulations to accommodate the dependence between the probabilities of default (PD) and the losses given default (LGD) with arbitrary marginal distributions. The PD-LGD link is introduced via the single systematic risk factor and its strength is controlled via a dedicated parameter, in line with the treatment of the default dependence in the current Basel framework. We derive the explicit form of the mapping function translating unconditional LGDs into conditional ones, compute the portfolio-invariant semi-analytical formula of value-at-risk and propose a calibration method. An empirical study featuring defaulted corporate bonds confirms the validity of the calibration procedure and delivers realistic risk metrics. The proposed approach is easy to implement and is useful to design future guidelines for capital requirements, to perform sensitivity analysis or to compute implied downturn LGDs. Compared to the guidelines of the European Banking Authority, our approach delivers more conservative figures on the considered data.

Suggested Citation

  • Barbagli, Matteo & Vrins, Frédéric, 2023. "Accounting for PD-LGD dependency: A tractable extension to the Basel ASRF framework," Economic Modelling, Elsevier, vol. 125(C).
    • Handle: RePEc:eee:ecmode:v:125:y:2023:i:c:s0264999323001335
    DOI: 10.1016/j.econmod.2023.106321
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    References listed on IDEAS

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    More about this item

    Keywords

    Credit risk; Factor model; Value-at-risk; Basel regulation; Downturn LGD;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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