A practical anatomy of IRC modelling

ABSTRACT This paper considers the different elements of modeling the so-called incremental risk charge. We show the increasing regulatory requirements, as well as the reasoning behind this. We start our analysis by introducing a generic multifactor multistate credit risk model (CRM). Then we compare the economic needs for credit risk modeling with the regulatory requirements for the incremental risk charge and successively reduce the complexity of the CRM to meet these regulatory requirements. We analyze in depth the different steps of this simplification, ie, factor reduction, migration matrices and valuation grids. This results in a very efficient semianalytical incremental risk charge model that is still consistent with the CRM.This analysis gives us newinsight into the mechanics of both approaches and thus into the models'anatomies. The efficient and consistent reduction of complexity is highly relevant to practical applications.We emphasize our analysis by applying the different approaches to a real-life example portfolio.