Bankrupt UK cities: PD model for credit risk in sub-sovereign sector

We develop a PD model (PD – probability of default) for sub-sovereign entities, namely UK municipalities. Our methodology serves as an alternative for banks that use the standardised approach or scorecard-based models for assessing the probability of default for municipalities, local authorities and other sub-sovereign entities. Focusing on credit exposures to municipalities, we address the concerns that sub-sovereign and sovereign entities are nowadays more risky than large corporate or bank entities. Furthermore, discussing the current and forthcoming regulatory frameworks for credit risk models, we point to the existence of contradictory regulations and argue that dispensing with the conservative approach may lead to a build-up of credit risk that cannot be accurately captured. With this in mind, we argue that PD models should remain conservative so that banks can accumulate sufficient capital to cover the crisis-induced default exposures.