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Point-in-time loss-given default rates and exposures at default models for IFRS 9/CECL and stress testing

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In contrast with Basel II rules, which call for the use of through-the-cycle (TTC) probabilities of default (PDs) and downturn (DT) loss-given default rates (LGDs) and exposures at default (EADs), the regulatory stress tests and the new IFRS 9 and proposed Current Expected Credit Loss (CECL) accounting standards require institutions to use point-in-time (PIT) projections of PDs, LGDs and EADs. By accounting for the current state of the credit cycle, PIT measures track closely the variations in default and loss rates over time. In past publications the authors have described the derivation of industry-region credit-cycle indices (CCIs) and the use of those indices in converting legacy wholesale credit PD models, which typically understate cyclical variations, into fully PIT ones. This paper extends that framework to cover estimation of PIT LGDs and EADs for wholesale exposures. The authors offer options for the formulation of such models and discuss their experience in building PIT LGD and EAD models, and show that, by accounting for the probabilistic evolution over time in industry-region CCIs, one can derive joint, PD, LGD and EAD scenarios for use in the regulatory stress tests or in estimating the term structures of expected credit losses (ECLs) as needed for IFRS 9/CECL.
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Keywords: IFRS 9/CECL; expected credit loss (ECL); exposure at default (EAD); loss-given default (LGD); point-in-time (PIT); stress testing; through-the-cycle (TTC)

Document Type: Research Article

Publication date: June 1, 2016

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  • Journal of Risk Management in Financial Institutions is the essential professional and research journal for all those involved in the management of risk at retail and investment banks, investment managers, broker-dealers, hedge funds, exchanges, central banks, financial regulators and depositories, as well as service providers, advisers, researchers and academics. Guided by expert Editors and an eminent Editorial Board, each quarterly 100-page issue does not publish advertising but rather in-depth articles, reviews and applied research by leading professionals and researchers in the field on six key inter-related areas: strategic and business risk, financial risk, including traditional/exotic credit, market and liquidity risks, operational risk, regulatory and legal risks, systemic risk, and sovereign risk.

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