IFRS 9 compliant economic adjustment of expected credit loss modeling

This paper presents an International Financial Reporting Standard 9 (IFRS 9) compliant solution related to expected credit loss modeling. Commonly, credit default swap (CDS) spreads are considered as market indicators of future debt performance. However, we demonstrate empirically that nondefault risks explain a relevant part of the CDS spread, and we assess the average weight-of-default component for each point in the CDS spread term structure. Thus, to be used for probability of default estimations, CDS spreads must be adjusted for the nondefault component to guarantee the neutral character of expected credit loss estimations, as required by IFRS 9. Our study introduces an innovative methodology for extracting the pure default component and probability of default calibration. To enable economic adjustment of probabilities of default we analyze the relationship between a long-run average of the across-the-sample mean CDS spread of the homogeneous cohort of issuers and the spread implied by the long-run average of the observed default rates. Our easy-to-implement solution is applied to a sample of investment-grade and high-yield corporate debt issuers. We exploit differences in the economic performance of North American and eurozone obligors. The proposed framework allows us to understand complex interactions between the forward-looking impairment provisions and economic capital requirements in relation to credit losses.