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Cyclical adjustment of point-in-time PD

Author

Listed:
  • S Ingolfsson

    (Riskmanagement Ltd.)

  • B T Elvarsson

    (Íslandsbanki, University of Iceland)

Abstract

Banking regulation stipulates that to calculate minimum capital requirements a long-term average of annual default probability (PD) should be used. Typically, logistic regression is applied with a 12-month sample period to obtain retail PD estimates. Thus the output will reflect the default rate in the sample, and not the long-term average. The ensuing calibration problem is addressed in the paper by a ‘variable scalar methodology’, based on an actual application in a commercial bank. Using quarterly intra-bank loss data over 15 years, a state-space model of the credit cycle is estimated by a Kalman filter, resulting in a structural decomposition of the credit cycle. This yields an adjustment factor for each point in the cycle for each of two client segments. The regulatory compliance aspects of such a framework, as well as some practical issues are presented and discussed.

Suggested Citation

  • S Ingolfsson & B T Elvarsson, 2010. "Cyclical adjustment of point-in-time PD," Journal of the Operational Research Society, Palgrave Macmillan;The OR Society, vol. 61(3), pages 374-380, March.
  • Handle: RePEc:pal:jorsoc:v:61:y:2010:i:3:d:10.1057_jors.2009.136
    DOI: 10.1057/jors.2009.136
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    References listed on IDEAS

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    1. Kritzinger, Nico & van Vuuren, Gary Wayne, 2021. "Non-capital calibration of bureau scorecards," The Quarterly Review of Economics and Finance, Elsevier, vol. 79(C), pages 260-271.

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