Modifications on default probability calculation methods of commercial banks in China

This paper analyses two methods of calculating default probability adopted by foreign companies. Then, the paper suggests several methods of calculating loan default probability applicable to commercial banks in China, and gives the inadequacy of historic data in China.

Determination of Credit Risk Charges for Malaysian Life Insurance Industry： An Application of Default Probability

The objective of this paper is to measure the risk charge for credit risk as one of the components in the risk based capital of the capital adequacy framework. Currently, the risk charge for credit risk is measured by referring it to the credit rating of a company. Following the subprime crisis in 2007, the markets start to question the soundness of the credit rating issued as it has resulted in an inadequate risk charge. Therefore, this study attempts to determine the risk charge for credit risk using the probability of default （PD） for life insurers in Malaysia. The credit risk has been categorized into several types of debt obligations. Whereby, the KMV-Merton model has been used to measure the distance to default and estimate the probability of default. The estimation of default probability is based on the movement in the price index of several debt obligations. The price index of debt obligations from year 2004 to 2009 is collected inclusive of the subprime crisis period during the crisis period. Therefore, Malaysia insurance industry is The results found that the risk charges are lower not affected by the subprime crisis in 2007.

Corporate Probability of Default(PD)Modelling for Banks in Emerging Economies:A Case Study of Zimbabwe Stock Exchange(ZSE)Listed Counters

The paper extends Merton’s Probability of Default(PD)model to the case for transaction costs or market friction for estimation of the PDs of listed banking corporations.A closed form formula for the PD model is obtained and validated using financial data drawn from banks listed on the Zimbabwe Stock Exchange(ZSE).It has been observed that most corporations in emerging economies have been finding it extremely difficult to list,continue listed or manage risk emanating from credit exposures undertaken.In the absence of risk the role of the financial sector of an economy to efficiently and effectively allocate resources between the public and private sectors would be simplified,economically and rationally determined.Reliable or precise computation of the Probability of Default(PD)of a borrower is one of the most critical tasks in credit risk management for commercial banks that were applying the Internal Rating Based Approach(IRBA)under the Basel Capital Accords Ⅱ and Ⅲ frameworks.The study sought to develop a Probability of Default(PD)model that banking corporations in emerging economies such as Zimbabwe could adopt and implement in the Multiple Currency System(MCS)in their desire to grow and develop through their lending businesses.The research study adopted a PD model similar to the Asset Valuation Model(AVM)by Merton(1974)and initially extended by Black-Scholes(1973)and Crouhy et al.(2000)and applied it on a basket of Zimbabwe Stock Exchange listed counters after having adjusted the model for the transaction cost variable.The study therefore succeeded in coming up with a PD model that was worth adopting and implementing by Zimbabwe Stock Exchange(ZSE)listed corporations in their desire to grow towards sustainable development.It was realised that a contemporary PD model adjusted for transaction cost is pertinent for reflection of practical conditions banks face in estimation of their risk metrics such as PD.Transaction costs faced by banks in emerging economies are very huge that they cannot be assumed to be insignificant when it comes to valuation of PDs of banking corporations.The inclusion of transaction costs in estimation of PDs of ZSE listed banks is likely to create a paradigm shift in financial theory on risk metrics in the modern world.The study ends by recommending the need for all Zimbabwean listed corporations to adopt and implement an AVM adjusted for transaction costs if they were to successfully measure and manage both their investment and credit exposure endeavours in the multiple currency system period.

Econometric Model to Estimate the Probability of Default and Loss Given Default in the EBA Stress Test in 2016

In this research,an econometric with panel data using Ordinary least squares OLS model is constructed following the guidelines recommended by the EBA stress test methodology for 2016.The findings indicate that macroeconomic factors affecting defaults are the expected ones in the Spanish credit institutions.However,loan impairments do not follow the patterns that a priori would be normal.Divergent is outcomes in defaults and impairments:the Non-Performing Loans(NPL)is pro-cyclical and impairment losses are counter-cyclical.

Cumulative Effect of Debt and Tax on Firm Value:Optimal Capital Structure Theories in the Light of EMM

We have shown that cornerstone articles considering effects of corporate debt on the firm value and constituting the basis of the trade-off theory of capital structure are wrong.Their main mistake is in ignoring the business securing expenses(BSEs).In the framework of the extended Merton model(EMM),we consider the cumulative effect of debt and corporate taxes on the firm value and its survival,in other words,we revisit Modigliani-Miller Proposition 3(MMP3).We show that(1)debt affects the firm value and its survival,(2)this effect is negative,diminishing the firm value and its chances to survive,(3)the pressure increases as the debt grows provoking the firm’s default,(4)the main factors depressing the levered firm are its debt payments added to the BSEs of the identical unlevered firm and the length of debt maturity,(5)corporate taxes cause development of positive skewness in the asset distribution,but do not affect the location of this distribution in the asset axis.The presented model helps estimate the consequences of choosing this or that level of debt in the presence of corporate taxes and can make a useful instrument for practicing financial managers.

Evaluation of Deposit Insurance Fund Adequacy Using Credit Risk Model--An Indian Experience

There are two methods widely used for evaluating the adequacy of Deposit Insurance Fund： （i） Target Reserve Ratio and （ii） Credit Risk Model. Target Reserve Ratio is one of the macro level indicators more often set by Regulatory act on the basis of minimum Deposit Insurance Fund margin safety, Target Reserve Ratio is calculated as the ratio of Deposit Insurance Fund to the value of insured deposits. However, TRR does not take into consideration the level of Deposit Insurance potential liability, the Loss at Given Default （LGD） and the historical trend of default rate prevailing among the insured banks. It does not also consider the present condition of the economy and current scenario of the banking sector. This paper discusses primarily about development of Credit Risk Model for evaluating the Deposit Insurance Fund Adequacy. For this purpose, Econometric Credit Risk Model was developed based on the historical data of bank failures and the associated losses of the last 25 years from 1990-91 to 2014-15. The model assesses various possible factors impacting the Deposit Insurance Fund： Default rate, Deposit growth, Exposures, impact of macro-economic factors like GDP, GDS, Inflation and Interest rate changes, etc. on the Deposit Insurance Fund through econometric modeling. The model evaluates the adequacy of Deposit Insurance Fund under both （i） Normal scenarios where there is no （economic） systemic risk assumed and （ii） Worst case scenario at 1% level of significance using Monte Carlo Simulation. Since the model empirically validates all the critical factors impacting the assets and liabilities associated with Loss at Given Default, the model output can also be used to determine a suitable Target Reserve Ratio and such models are being used in countries like USA, Canada, Hong Kong, and Singapore, etc. （IADI, 2009）. More importantly, the model outputs are quite useful in determining the adequacy of deposit insurance fund which is an effective risk control measure that organization like Deposit Insurance Credit Guarantee Corporation （DICGC） can adopt both under normal economic scenario as well as worst case scenario, ensuring a strong financial safety net for the banking sector in India. The model also assesses the default probability and the Loss at Given Default of different types of banks： commercial banks, rural banks, cooperative banks, foreign banks, etc. A risk based on premium can possibly be determined for each type of banks in India.

No-Arbitrage in Financial Economics: Solution of the Mystery of Implied Volatility and S&P 500 Volatility Index

We have shown that classic works of Modigliani and Miller, Black and Scholes, Merton, Black and Cox, and Leland making the foundation of the modern asset pricing theory, are wrong due to misinterpretation of no arbitrage as the martingale no-arbitrage principle. This error explains appearance of the geometric Brownian model (GBM) for description of the firm value and other long-term assets considering the firm and its assets as self-financing portfolios with symmetric return distributions. It contradicts the empirical observations that returns on firms, stocks, and bonds are skewed. On the other side, the settings of the asset valuation problems, taking into account the default line and business securing expenses, BSEs, generate skewed return distributions for the firm and its securities. The Extended Merton model (EMM), taking into account BSEs and the default line, shows that the no-arbitrage principle should be understood as the non-martingale no arbitrage, when for sufficiently long periods both the predictable part of returns and the mean of the stochastic part of returns occur negative, and the value of the return deficit depends on time and the states of the firm and market. The EMM findings explain the problems with the S&P 500 VIX, the strange behavior of variance and skewness of stock returns before and after the crisis of 1987, etc.

Effect of Corporate Debt on Firm Value

We have shown that three classic works considering the effects of corporate debt on the firm value,namely,Modigliani and Miller(1958,1963),Merton(1974),and Leland(1994),are wrong.Their main mistake is ignoring the business security expenses,BSEs.We suggest the model taking account of BSEs and apply it to the analysis of debt influence on the firm value and survival.Our modeling demonstrates that(1)the debt affects the firm value and its survival,(2)this influence is negative,diminishing the firm value and its chances to survive,(3)the pressure of the negative effect of debt increases as the debt grows,provoking the firm default.The debt can be beneficial for the firm if the loan is taken to improve its technology.The model helps estimate the chances to succeed in the technological modernization for various parameters of the firm and its business environment;and by that,to find the technology most suitable for the firm.It is shown that there is a serious problem in reading the market signals concerning a firm and using this information to control this firm.

Some Financial Problems in the Light of EMM Results:Asset Pricing and Efficient Portfolio Allocation

Discussing results in asset pricing and efficient portfolio allocation,we show that mixed success and errors in these results often follow from a lack of information about the asset return distribution and wrong assumptions about its properties.Some mistakes in asset pricing come from the assumption of symmetry in return distributions.Some errors in efficient portfolio allocation follow from Markowitz’s approach when applying it to portfolio optimization of skewed asset returns.The Extended Merton model(EMM),generating skewed return distributions,demonstrates that(i)in skewed asset returns,the variance is not an adequate measure of risks and(ii)positive skewness in the asset returns comes together with a high default probability.Thus,the maximization of the mean portfolio returns and skewness with controlled variance used in mainstream papers can critically increase portfolio risks.We present the new settings of the optimal portfolio allocation problem leading to less risky efficient portfolios than the solutions suggested in all previous papers.

Measuring Real Capital Adequacy in Extreme Economic Conditions： An Examination of the Swiss Banking Sector

The global financial crisis （GFC） has placed the creditworthiness of banks under intense scrutiny. In particular, capital adequacy has been called into question. Current capital requirements make no allowance for capital erosion caused by movements in the market value of assets. This paper examines default probabilities of Swiss banks under extreme conditions using structural modeling techniques. Conditional Value at Risk （CVaR） and Conditional Probability of Default （CPD） techniques are used to measure capital erosion. Significant increase in Probability of Default （PD） is found during the GFC period. The market asset value based approach indicates a much higher PD than external ratings indicate. Capital adequacy recommendations are formulated which distinguish between real and nominal capital based on asset fluctuations.

Credit Spreads,Probability of Default and Debt Risk Measurement of Prefectural Governments in China:2014-2017

In this paper,the concepts of probability of default,loss given default and expected loss in the internal ratings-based approach are introduced into the measurement of local government debt risk.Based on issuing interest rate and credit spreads of provincial government bonds,the default probability models of general debt and special debt are constructed and estimated,and the general and special debt risk of 333 prefectural governments in China from 2014 to 2017 are estimated respectively,and their regional distribution and changes are analyzed.The conclusions are as follows:Both general and special debt risk are different among regions.In terms of vertical changes in 2014-2017,debt risk has increased on the whole,but this increase has been driven more by the increase in the size of the debt,with no significant change in the probability of default,and the debt risk is concentrated in a small number of prefectural governments.The general debt risk accounts for about two-thirds of the total debt risk,the special debt risk accounts for about one-third,and this proportion structure is basically unchanged in 2014-2017.Based on the above conclusions,this paper puts forward corresponding policy recommendations for governance and control of local debt risk.

Research on Credit Default Swaps Pricing Considering Moral Hazard Incentive under Reduce-Form Model

Equilibrium pricing of credit default swaps(CDS)promotes efficient identification of credit risk in the market,which in turn leads to efficient allocation of resources.However,even when CDS have been priced in equilibrium,i.e.,when premiums are equal to anticipated payments,the moral hazard incentives of CDS buyers increase with CDS transactions.Consequentially,it becomes an interesting research direction to study the impact of moral hazard incentives on the trading mechanism or pricing of derivatives(CDS).Most of the existing literature on the impact of moral hazard incentives in CDS pricing on derivatives trading mechanisms takes a macro perspective and focuses on the agreement risk effect.The literature exploring the analysis of the impact of moral hazard on the probability of agreement default from a micro perspective is not yet available.With this in mind,this paper focuses on the mechanisms by which“fraud”,an extreme manifestation of micro-moral hazard incentives,affects the probability of default.This paper introduces for the first time the concept of“claiming fraud”by credit protection buyers,which is different from the macro perspective of moral hazard incentives,and thus defines a specific extreme form of moral hazard incentives.Meanwhile,to address the intrinsic feature of the lack of economic explanatory power of the reduce-form model,this paper introduces a moral hazard incentive factor into the reduce-form model,and proposes a moral hazard state variable as a function of the asset value of the reference entity,which gives the reduce-form model strong economic explanatory power,and the default predictability is reduced by the description of the reduce-form model.In terms of the object of study,this paper considers the issue of moral hazard incentives in the presence of claiming fraud in two reference entities to further explore the impact of moral hazard incentives on default protection at the micro level in terms of cyclic default.Finally,based on the analysis of the results of the numerical simulation experiments,it is proposed that increasing the number of reference assets for CDS buyers will help to reduce the moral hazard incentives of the buyer,and thus the anticipated payments to the buyer,i.e.,we attempt to endogenize the credit risk of an asset by allowing the asset holder to choose the probability of the asset going up or down,which helps to understand the phenomenon of moral hazard incentives in CDS trading.

PARAMETRIC AND NON-PARAMETRIC COMBINATION MODEL TO ENHANCE OVERALL PERFORMANCE ON DEFAULT PREDICTION

The probability of default(PD) is the key element in the New Basel Capital Accord and the most essential factor to financial institutions' risk management.To obtain good PD estimation,practitioners and academics have put forward numerous default prediction models.However,how to use multiple models to enhance overall performance on default prediction remains untouched.In this paper,a parametric and non-parametric combination model is proposed.Firstly,binary logistic regression model(BLRM),support vector machine(SVM),and decision tree(DT) are used respectively to establish models with relatively stable and high performance.Secondly,in order to make further improvement to the overall performance,a combination model using the method of multiple discriminant analysis(MDA) is constructed.In this way,the coverage rate of the combination model is greatly improved,and the risk of miscarriage is effectively reduced.Lastly,the results of the combination model are analyzed by using the K-means clustering,and the clustering distribution is consistent with a normal distribution.The results show that the combination model based on parametric and non-parametric can effectively enhance the overall performance on default prediction.