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Internal risk models and the estimation of default probabilities


  • Jens H. E. Christensen


A major advancement in risk management among large financial institutions has been the development of internal risk models. The models encompass institutions' procedures and techniques for assessing portfolio risk. Commercial bank regulators in the U.S. and abroad have recognized that these "state of the art" risk-management tools provided a framework for addressing important shortfalls of current capital regulations. To that end, a key component of the new rules for bank capital regulation developed under the Basel II agreement allows for banks' internal risk-management systems to be part of the regulatory framework. This is known as the advanced approach and is intended for the largest and most sophisticated banking organizations. ; Key elements of internal risk models used under the advanced approach are the estimated probabilities of default (PDs) for bank assets. For example, a bank using the advanced approach would be required to deliver an estimate of the one-year PD for each corporate exposure. This Economic Letter describes some of the problems involved in estimating the required one-year PDs from banks' internal ratings data and details the approach taken in Christensen, Hansen, and Lando (2004) to address them.

Suggested Citation

  • Jens H. E. Christensen, 2007. "Internal risk models and the estimation of default probabilities," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue sep28.
  • Handle: RePEc:fip:fedfel:y:2007:i:sep28:n:2007-29

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    References listed on IDEAS

    1. Charles I. Jones, 2005. "More life vs. more goods: explaining rising health expenditures," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue may27.
    2. Mark Duggan & Fiona M. Scott Morton, 2006. "The Distortionary Effects of Government Procurement: Evidence from Medicaid Prescription Drug Purchasing," The Quarterly Journal of Economics, Oxford University Press, vol. 121(1), pages 1-30.
    3. Ho, Vivian & Town, Robert J. & Heslin, Martin J., 2007. "Regionalization versus competition in complex cancer surgery," Health Economics, Policy and Law, Cambridge University Press, vol. 2(01), pages 51-71, January.
    4. Thomas C. Buchmueller & Robert G. Valletta, 2006. "Health insurance costs and declining coverage," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue sep29.
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    Banks and banking ; Risk;


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