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A coherent economic framework to model correlations between PD, LGD and EaD, and its applications in EaD modelling and IFRS-9

Author

Listed:
  • Miu, Peter

    (Professor of Finance, DeGroote School of Business, McMaster University, Canada)

  • Ozdemir, Bogie

    (EVP & CRO, Canadian Western Bank, Canada)

Abstract

This paper proposes an economic framework recognising EaD as a stochastic variable and capturing the PD–LGD, PD–EaD and LGD–EaD correlations. It explains how these correlations can be estimated from historical data, and how PD, LGD and EaD can then be simulated in determining credit VaR. The framework allows credit losses to be more accurately captured, both in terms of the expected credit losses (ECL under IFRS-9 and CECL) and the unexpected tail events in measuring Credit VaR. The framework quantifies the potential underestimation of the tail risk in Credit VaR and the IFRS-9 ECL if the full correlation structure is not captured. By explicitly modelling EaD in a correlated fashion with PD and LGD, lenders can understand and model the increase in funding requirements during downturns. Application in back-testing IFRS-9 ECL is discussed and supplemented by a numerical example.

Suggested Citation

  • Miu, Peter & Ozdemir, Bogie, 2023. "A coherent economic framework to model correlations between PD, LGD and EaD, and its applications in EaD modelling and IFRS-9," Journal of Risk Management in Financial Institutions, Henry Stewart Publications, vol. 16(1), pages 52-78, January.
    • Handle: RePEc:aza:rmfi00:y:2023:v:16:i:1:p:52-78
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    More about this item

    Keywords

    IFRS-9; PD-LGD-EaD correlations; EaD modelling; CECL; Basel; credit VaR;
    All these keywords.

    JEL classification:

    • G2 - Financial Economics - - Financial Institutions and Services
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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