Further, each counterparty is characterised by an average (over the ex-

ternal influence y) PD and LGD, which are typically estimated by an in-

ternal rating methodology also used within the IRB framework
1
:
(4)
The so-called systematic portfolio risk relates to (unexpected) credit port-
folio losses, which are due to the influence of the external random vari-
able y and hence cannot be diversified away. Mathematically speaking, the
systematic portfolio loss conditional on y is defined as:
(5)
The correlation between default rates and LGD rates is due to their com-
mon dependence on the external influence y, which is not an observable
variable unlike defaults and default losses.
To incorporate this dependence into our model for the systematic loss
(5), we follow the ansatz of Altman et al (2003), who estimated an econo-
metric relationship between default rates p
i
(y) and average LGD rates
i
(y)
based on yearly historical data, which we will denote by
^
i
(p
i
). To use a sim-
ilar approach to express the average LGD rates as a function of the default
rates, we have to assume that the historical data set used for the economet-
ric estimate is sufficiently granular in time, that is, when using yearly data
we have to assume that the unobservable external influence y is (approxi-
mately) constant during the year. This is a reasonable assumption since y
models the business cycle, which is typically much longer than one year. It
is important to mention that a relationship of the form
^
i
(p
i
) only expresses
the average LGD rates depending on the current default rates, whereas the
actual default loss x
i
of a certain counterparty i remains a random variable,
which will be important when discussing unsystematic credit risk below.
Replacing
i
(y) by the econometric relationship
^
i
(p
i
) in equation (5)
we can write the systematic credit portfolio loss as:
(6)
Calibration
We would like to estimate an econometric function
^
i
(p
i
) to describe the re-
lationship between default rates and LGD rates based on historical data. As
explained above, we can assume that the external influence y is approximately
constant during a year (since the business cycle is typically longer than one
year) and hence yearly default and LGD data can be interpreted as a set of
data points (

i
, p

i
) = ((y
i
), p(y
i
)) with i indexing the years of observation.
Altman et al (2003) used default rates and LGD data for US corporate
exposures from 19822001 to estimate various econometric functions de-
L y E p y p y
s i
i
N
i i i
( ) ( ) ( ) ( )

L y E E x y p y E y p y
s i
i
N
i i i
i
N
i i
( ) ( ) ( ) ( ) ( )


1 1

PD p y h y dy
LGD y h y dy
i i
i i
( ) ( )
( ) ( )

M
ost credit portfolio models calculate a portfolio loss distribution
for credit default losses using either analytic models or Monte Carlo
simulation, assuming that recovery rates are statistically indepen-
dent of default rates, very often with the additional simplification of as-
suming constant recovery rates (Wilson, 1997, Saunders, 1999, Gordy, 2000,
and JP Morgan, 1997). The model underlying the Basel II internal ratings-
based (IRB) capital calculation (Wilde, 2001a, and Basel Committee, 2003)
is simplified even further by measuring systematic credit portfolio losses
only, that is, portfolio losses that are due to external influences and hence
cannot be diversified away.
Various recent empirical studies (Frye, 2000a, 2000b and 2003, and Alt-
man et al, 2003) have shown there is significant correlation between default
rates and recovery rates for corporate exposures, which can be explained
by their common dependence on the business cycle. During recessions, the
assets of firms tend to be lower, resulting in higher default rates. At the same
time, the market value of collaterals tends to be lower, resulting in higher
average loss given default rates (that is, lower recovery rates).
In the following, we will derive an econometric relationship between
default rates and loss given default (LGD) rates, which we calibrate using
historical data for corporate exposures and then incorporate into a single-
factor model for measuring systematic credit portfolio risk. As a last step,
we use the analytic concept presented in Wilde (2001b), Gourieroux, Lau-
rent & Scaillet, 2000, Martin & Wilde, 2002, and Gordy (2003) to extend
the approach to measuring unsystematic credit portfolio risk as well. Fur-
ther, we will present several numerical examples showing the impact of
probability of default (PD)/LGD correlations on both systematic and un-
systematic credit risk models and economic capital.
Systematic credit portfolio risk
We assume a credit portfolio of N counterparty exposures E
i
and let p
i
(y)
denote the PD of counterparty i, conditional on external influences sum-
marised in the vector y R
n
(for n = 1 we have the special case of a sin-
gle-factor model, summarising the business cycle in one (random) variable
y). Further, we let the random variable x
i
[0, 1] denote the LGD of coun-
terparty i in the case of default, which is described by a probability den-
sity function conditional on y (to incorporate the dependence of LGD rates
on the business cycle), that is, g
i
(x
i
| y), which has to fulfil the conditions:
(1)
Further, we have the average LGD
i
(y) conditional on y and the expect-
ed loss defined as:
(2)
(3)
where h(y) denotes the probability density function of the external in-
fluence y.
EL p y y h y dy
i i i
( ) ( ) ( )

i i i i i
y x g x y dx ( ) ( )

0
1
g x y x g x y dx y
i i i i i i
( ) [ ] ( )

0 0 1 1
0
1
, and
WWW.RISK.NET

APRIL 2005 RISK 79
Credit portfolio risk
l
Cutting edge
The impact of PD/LGD correlations
on credit risk capital
Empirical studies show that default probabilities and loss given defaults of corporate
counterparties are positively correlated due to their common dependency on the business
cycle. Guido Giese applies econometric estimates of correlations between default rates and
loss given default rates to modern credit portfolio models to quantify their impact on the
calculation of credit risk capital
1
The advanced IRB approach of Basel II requires banks to estimate PD and LGD for each
counterparty, based on historical data covering at least one full business cycle (Basel
Committee, 2003)
scribing the relationship between default rates and LGD rates, which are
summarised in table A.
The problem with the functions indicated in table A is that they do not
fulfil the requirement for the average losses that:
(7)
which is due to the fact that in Altman et al (2003) the historically observed
default rates in the data set were limited to the interval [0.0084; 0.01027].
However, in the general case the functions p
i
(y) may assume any value in
[0; 1] (for example, when using the Merton model, which we will exem-
plify below) and hence we have to use an econometric function that ful-
fils the condition (7).
The main problem is that empirical observations of the extreme cases
p 0 and p 1 are not available and hence we have to make plausible
assumptions for these cases. To be conservative, we assume
2
:
(8)
The rationale behind equation (8) is the fact that in the limit y all
counterparties default (independent of the counterpartys PD
i
) and hence
all collaterals have zero market value, resulting in an LGD rate of one.
Analogously, we assume in the optimistic scenario that:
(9)
With a parameter 0 a
0
< 1, which we will determine within the calibra-
tion. Furthermore, we assume that average LGDs are increasing in the PD
due to their common dependence on the business cycle, that is:
(10)

i
p p

( ) [ ] 0 0 1 ;
lim
p
i
p a

( )
0
0

lim
p
i
p

( ) ( )
1
1

worst-case scenario

i
p p ( ) [ ] [ ] 0 1 0 1 ; ;
To fulfil the requirements (8)(10), we use an ansatz of the follow-
ing form:
(11)
We estimate the parameters a
0
, a
1
and a
2
based on the historical data set
of Altman et al (2003). In principle, a
0
, a
1
and a
2
could be calculated by a
least-squares algorithm, which has the advantage that we obtain a model
function
^
i
(p) that is independent of the choice of the model functions
p
i
(y) and h(y), that is, it can be applied in a wide range of single-factor or
multi-factor models.
However, the disadvantage of the least-squares estimate is that the ex-
pected loss calculated according to:
(12)
does not necessarily coincide with the empirically observed expected loss
of our data sample. Hence, the alternative is to calculate the parameters
a
0
, a
1
and a
2
by minimising a least-squares function under the constraint
EL = 3.16% (which is the average expected loss of our data sample from
Altman et al, 2003), which we perform using a Lagrange optimisation below
for the one-factor model. The reason for using this constraint is that we
want to make sure that the worst-case assumption (8) does not influence
the average loss behaviour observed in historical data.
Example Merton default model
To illustrate the impact of PD/LGD correlations on credit portfolio mod-
els, we will use the Merton model as the underlying default model. The
Merton model is widely used in the financial industry, for example, for
pricing collateralised debt obligations (CDO, Vasicek, 2003) or as the un-
derlying model of the Basel II IRB approach (Wilde, 2001a, and Basel Com-
mittee, 2003).
For a portfolio of N exposures E
i
, the counterparty i defaults if its asset
return r
i
falls below a certain threshold T
i
, where the returns are influenced
by one common factor y R (representing the influence of the business
cycle, also referred to as systematic risk factor) and one individual unsys-
tematic risk factor
i
per counterparty. Under the Merton approach, y and
the
i
are independent standard normally distributed random variables
(with h(.) = (.) = N(.) denoting the standard normal density) and hence
the asset returns under this approach:
(13)
are also standard normally distributed, where
i
denotes the asset cor-
relation. Consequently, the default threshold T
i
can be calculated from
the counterpartys PD
i
and the cumulative standard normal distribution
N(.) by:
(14)
Further, the conditional probability of default given y for counterparty i
reads:
(15)
Calibration for non-investment-grade corporate exposures. To cal-
ibrate the model function (11) to historical data for non-investment-grade
exposures, we have to use the data of counterparties of (approximately)
the same risk profile (that is, approximately the same PD
i
, EL
i
and PD/LGD
correlations). We use the data used in Altman et al (2003) for non-invest-
ment-grade US corporate exposures from 19822001 and calibrate the pa-
rameters by a least-squares estimate for the model function (11) under the
constraint EL = 3.16%(which is the average loss over time of the data sam-
ple), that is, with

j
, p

j
j = 1982... 2001 denoting the yearly historical LGD
rates and default rates we use the Lagrange function for counterparty i:
p y P r T y N y T y N
T y
i i i i i i i
i i
i
( ) < ( ) + <
( )

_
,

1
1
T N PD
i i
( )
1
r y
i i i i
+ 1
EL p y p y h y dy
i
i
i i
( ) ( ) ( ) ( )

i
a
a
p a p ( )
( )
1 1
0
1
2
80 RISK APRIL 2005

WWW.RISK.NET
Cutting edge
l
Credit portfolio risk
A. Econometric functions
Estimated econometric function R
2
1 = 0.51 2.61 p 0.51
1 = 0.61 8.72 p + 54.8 p
2
0.65
1 = 0.002 0.113 ln(p) 0.63
1 = 0.138/p
0.29
0.65
Average figures 19822001: PD = 4.19%, EL 3.16%
Note: econometric functions estimated based on historical data for corpo-
rate defaults from 19822001 and average probability of default (PD) and
average expected loss (EL)
1. Plot of the calibrated function and the
historical data points
0.4
0.5
0.6
0.7
0.8
0.9
1.0
0.1e1 0.1 1.0
Probability of default
L
o
s
s

g
i
v
e
n

d
e
f
a
u
l
t
2
This assumption can be eased to
lim
p 1

^
i
(p) = a with a parameter a < 1 proceeding in the
same way as presented in the following
(on average) in lower losses under good economic conditions (that is, y >
0, because then low default rates tend to coincide with low LGD rates) but
(on average) in higher losses in unfavourable conditions (that is, y < 0,
where high default rates coincide with high LGD rates) and hence the tail
of the systematic loss distribution becomes fatter as indicated in figure
2 which can result in a higher value-at-risk at a certain confidence level.
Calibration for investment-grade corporate exposures. To diversi-
fy the numerical examples provided below, we calibrate our model func-
tion (11) for investment-grade corporate bonds based on historical data
provided in Moodys (2000). We use single-A default rates between 1980
and 2000 (average probability of default of 0.14%) for the calibration. Per-
forming the same steps as for non-investment-grade bonds, we obtain the
resulting model function linking default and LGD rates by:
(19)
The corresponding systematic portfolio loss is formed analogously to equa-
tion (17).
In the following numerical examples, we will always refer to the cali-
bration according to (16) as non-investment grade and the calibration (19)
as investment grade.
Calculation of systematic credit risk capital. Loss distributions of the
form L(y) such as (17) are typically used to estimate the economic capital
(or regulatory capital when using the loss formula (18) as in the IRB ap-
proach) to buffer the risk of a credit portfolio at a certain confidence level
q (for example, 1 q = 99.9% is used by the IRB approach):
(20) Capital VAR L L y N q
q
( ) ( ) ( )
1

i
p p ( )
( )
1 0 90736 1
0 30224
4 5948
.
.
.
which can be solved numerically yielding the model function:
(16)
Consequently, we assume a homogeneous portfolio in the following
represented by the model function (16) for all counterparties. Figure 1
shows the model function
^
i
(p
i
) with the data points used for the least-
squares calculation.
Thus using (16) in (6), we obtain the systematic credit portfolio loss for
the single-factor model including PD/LGD correlations:
(17)
It is important to mention that in the general case, one would have to esti-
mate a different model function
^
i
(p
i
) for each counterparty or at least for
each sub-portfolio/rating class of counterparties that can be described by (ap-
proximately) the same risk profile (that is, the same parameters PD
i
, EL
i
and
PD/LGD correlations), which then leads to a more complicated sum in (17).
It is interesting to compare the result (17) with the Vasicek model un-
derlying the Basel II IRB approach neglecting PD/LGD correlations (Wilde,
2001a, Basel Committee, 2003, and Vasicek, 2003), which is based on the
assumption of constant (that is, non-stochastic) LGD rates:
(18)
For both portfolio loss distributions (17) and (18), which are of the form
L(y), we plot the corresponding probability density function (y(L))(dy/dL)
using the inverse function y(L).
Figure 2 compares the probability density function of Vasiceks model
(18) used in the IRB approach with our model (17). Although both proba-
bility distributions are based on the same underlying default model (that is,
the Merton model), at the portfolio level the loss behaviour of the two is
quite different. Economically speaking, positive PD/LGD correlations result
L y E LGD N
T y
V i
i
n
i
i i
i
( )

_
,

1
1

L y E N
T y
s i
i
n
i i
i
( )

_
,

_
,

1
0 91044
11
1 0 6047 1
1
.
.
.

11042
1

_
,

_
,

N
T y
i i
i

i
p p ( )
( )
1 0 6047 1
0 91044
11 1042
.
.
.
L a a a p
p y p y
i j j
j
i i i
0 1 2
2
1982
2001
, , ,

( )
( )

( )
+
( ) ( ) ( )

yy dy ( )

_
,

0 0316 .
WWW.RISK.NET

APRIL 2005 RISK 81
2. Loss distribution with and without PD/LGD
correlations
0
5
10
15
20
25
30
35
0.05 0.10 0.15 0.20 0.25
P
r
o
b
a
b
i
l
i
t
y

d
e
n
s
i
t
y
Loss
Comparison of the systematic loss density distribution per exposure unit of the
IRB approach L
V
(red line) and the loss density including PD/LGD correlations
L
s
(blue line) for
i
= 15% and PD
i
= 4.19%. The latter has a higher probability
of very low losses (that is, under good economic conditions low default rates
tend to coincide with low loss rates) but also a higher probability of very high
losses (since under unfavourable economic conditions higher average default
rates coincide with higher average loss rates)
3a. Economic capital and Basel II capital for
non-investment-grade portfolio
0.1
0.2
0.5
0.90 0.92 0.94 0.96 0.98 1.00
1.15
1.20
1.25
1.30
0.90 0.92 0.94 0.96 0.98 1.00
C
a
p
i
t
a
l
Confidence level Confidence level
R
a
t
i
o
Left: economic capital per exposure unit for
i
= 15% and PD
i
= 4.19% (that is, non-
investment-grade exposures) based on the systematic credit loss function (17)
including PD/LGD correlations (red line) and the credit risk capital according to the
Vasicek model (18) (green line) as a function of the confidence level (between 0.9
and 1). Right: ratio of the systematic loss according to equation (17) and the loss
according to the Vasicek model (18) as a function of the confidence level. The
Vasicek model used by the IRB approach underestimates risk up to 35% for high
confidence levels
3b. Economic capital and Basel II capital for
investment-grade portfolio
0.1
0.2
0.3
0.4
0.5
0.90 0.92 0.94 0.96 0.98 1.00
1.15
1.16
1.17
1.18
1.19
1.20
0.90 0.92 0.94 0.96 0.98 1.00
Confidence level Confidence level
R
a
t
i
o
C
a
p
i
t
a
l
Capital figures (left) and ratio between economic capital and Basel II capital (right)
as a function of the confidence level for investment-grade exposures (PD
i
= 0.14%)
Figures 3a and 3b compare the systematic credit risk capital of the model
(17) including PD/LGD correlations with the capital based on model (18)
without correlations calculated using equation (20) for both. Non-invest-
ment-grade exposures are calibrated according to equation (16) and in-
vestment-grade exposures are calibrated in (19). For non-investment-grade
exposures (figure 3a) the ratio between these capital requirements increases
with the confidence level and reaches a value of 135% for high confidence
levels, such as 99.9% used by the IRB approach, which shows how sig-
nificant the influence of PD/LGD correlations is for calculating economic
capital. For investment-grade exposures, the behaviour is similar but the
impact of PD/LGD correlations is clearly lower, that is, about 22% in case
of very high confidence levels. This result is consistent with the findings
of other authors (Frye, 2000a and 2003, and Altman et al, 2003).
A simple alternative to estimating an econometric dependency such as
the model equation (11) and calculating capital taking into account PD/LGD
correlations as in equation (17) would be to capture the risk stemming
from PD/LGD correlations by higher than mean LGD figures (that is, con-
servative LGDs, for example, taking LGDs from years when PDs were
high) and then use the simpler formula (18) as proposed in the Basel II
Accord. This method is clearly more direct and easier to apply than using
an econometric function. However, the disadvantage would be reduced
accuracy, that is, comparing the loss function (17) to the simpler version
(18) one sees that the capital add-on for PD/LGD correlations clearly de-
pends on the input parameters, that is, the asset correlations and proba-
bility of defaults of the loans as well as the confidence level used. For that
reason, to ensure that the simple method of using adjusted LGD rates never
underestimates risk, one would have to use conservative (or worst-case)
LGD rates, which are sufficiently high to cover the additional risk due to
PD/LGD correlations for all types of portfolios. Consequently, in most cases
such a conservative model would calculate higher than necessary risk fig-
ures, compared with the more sophisticated model (17).
As a numerical example, we calculate and plot in figure 4 the ratio of
the capital requirements according to formula (17) and the simplified model
of conservative LGDs (using the highest LGD observed in the data set)
for both non-investment-grade and investment-grade exposures. It is in-
teresting to note that for confidence levels below about 99% the simple
method tends to overestimate risk (compared with the econometric model).
However, for confidence levels beyond 99% the simple model underesti-
mates risk, showing that simply assuming higher than average LGDs to
cover PD/LGD correlation risk might not always be the appropriate way
of modelling credit portfolio risk. As is often the case, the practitioner will
have to choose between the simplicity and the accuracy of his model.
Unsystematic portfolio risk
Here we investigate the impact of unsystematic credit risk on the economic
capital of a portfolio and show that for reasonably diversified portfolios
the additional capital requirement to cover idiosyncratic credit risk is quite
small. We exemplify our analysis for non-investment-grade exposures cal-
ibrated according to equation (17).
The systematic credit risk probability distribution function (17) neglects
unsystematic risk, that is, it only holds for a perfectly diversified portfolio.
In other words, the stochastic character of the loss given defaults x
i
is ne-
glected in the systematic loss function (17), that is, it is assumed that the
loss x
i
always attains the mean value
^
i
. Mathematically speaking, the sys-
tematic credit risk distribution is based on the assumption that:
(21)
with the Dirac distribution (.).
3
To promote a credit portfolio model that allows for stochastic LGDs x
i
,
we assume that the LGD distributions can be described by a beta-distrib-
ution, which in general is defined as:
(22)
with the beta function B(.) and two positive constants > 0, > 0. The
advantage of the beta distribution is that its mean m (0; 1) and variance

2
can be fitted to historical data, using the relationships:
(23)
To come to a model for the distributions g
i
(x
i
|y) we identify the mean
of the beta distribution with the econometric LGD mean
^
i
(p
i
), that is, for
each counterparty i we set:
(24)
Further, we have to model the volatility of the variable x
i
conditional on
y. In general, we can set:
(25)
with [0; 1], where the case = 1 corresponds to the extreme case of:
(26)
whereas the case = 0 is represented by equation (21) above.
Schuermann (2004) analysed LGD volatilities for corporate exposures
in the US and found a standard deviation of about 25% averaged over the
business cycle, with a low dependence on the exposure seniority. Hence,
we calibrate the factor to fulfil:
(27)
A numerical solution of (27) based on the model function (16) yields =
0.32, which we will use in the following. Further, we can conclude that
our empirical distribution is somewhere between the two extreme cases
= 0 represented by equation (21) and = 1 from equation (26).
Combining equation (16) and (22), we come to the model function for
the LGD distributions:
(28)
where the parameters and are calibrated using equations (24) and (25)
in equation (23).
To sum up, we calibrated the functions g
i
(x
i
|y) represented by a beta
distribution to historical data, that is:
the conditional mean
^
i
(p
i
) was fitted to historical data series (by least
squares);
fulfilling the constraint that the expected model loss equals the histori-
cal average loss of 3.16%;
g x y P x
i i i
( ) ( )
,


i
R
R
i i i
p y p y y dy

( ) ( ) ( ) ( )

1
]
( ) 1 0 25
2
.
g x y p y x p y x
i i i i i i
( ) ( ) ( ) + ( ) ( ) ( ) 1 1

i i i i i i i
y m m p y p y
2
1 1 ( ) ( ) ( ) ( ) ( ) ( )

1
]

m p
i i i
( )

m
m m m
m
m m m
, , ( )

( )
( )
+
( )
( )
2 2
2
2 2
2
1
P x
x x
B



,
,
( )
( )
( )

1
1 1
g x y x p y
i i i i i
( ) ( ) ( ) ( )

82 RISK APRIL 2005

WWW.RISK.NET
Cutting edge
l
Credit portfolio risk
4. Sophisticated versus simple approach
0.96
0.98
1.00
1.02
1.04
1.06
1.08
1.10
1.12
1.14
0.90 0.92 0.94 0.96 0.98 1.00
0.98
0.99
1.00
1.01
1.02
0.90 0.92 0.94 0.96 0.98 1.00
Confidence level Confidence level
R
a
t
i
o
L
R
a
t
i
o
Ratio of the systematic loss according to equation (17) and the loss according to
the Vasicek model (18) with conservative LGD rates as a function of the confidence
level for non-investment-grade exposures (left) and investment-grade exposures
(right). One observes that for very high confidence levels, taking higher than
average LGDs might underestimate risk or, put differently, the higher the confidence
level, the more conservative the LGDs have to be
3
The Dirac distribution of the form (x x
0
) describes a certain event, that is, it is defined
by the two properties i) (x x
0
) = 0 for x x
0
and ii) (x x
0
) dx = 1
variable granularity n
2
(calibrated according to equation (16)).
Further, we calculate and plot the ratio between the capital calculated
using equation (17) and the Basel II capital requirements according to equa-
tion (18) at a 99.9% confidence level for different values of n
2
(see figure 7).
As expected, one observes that the capital add-on to the Basel II re-
quirements is decreasing in the granularity n
2
of the non-investment-grade
sub-portfolio (whereas the investment-grade half of the portfolio is fixed),
but is clearly smaller than in the previous case of purely non-investment-
grade exposures.
the standard deviation of the LGDs x
i
around the conditional mean was
set to 25%, based on historical observations; and
fulfilling the requirements (1) and the worst-case assumption (8).
Figure 5 shows the calibrated functions g
i
(x
i
|y).
To calculate unsystematic risk based on the functions g
i
(x
i
|y), one would
have to perform a Monte Carlo simulation, taking random samples for the
systematic risk factor y and all unsystematic risk factors
i
in each scenario,
and then taking a sample of random LGD variables x
i
for those counter-
parties that fulfil the default criteria.
However, since the computational effort of Monte Carlo simulation
is immense for large portfolios, one seeks analytic methods for at least
calculating an approximation of the unsystematic credit portfolio loss
distribution.
In Wilde (2001b), an analytic approach was introduced for calculating
a granularity adjustment to the economic capital figure calculated using
the systematic loss L
s
(y) based on an expansion of the exact unsystemat-
ic loss distribution denoted by L(y) yielding a series for the VAR of the
exact loss as the VAR of the distribution of the systematic loss (5) plus cor-
rection terms. That is, according to Gordy (2003), we have:
(29)
Formula (29) is based on the systematic portfolio loss L
s
(y) and the con-
ditional variance of the unsystematic loss L, which we calculate as the vari-
ance of the portfolio loss for a given value of y, that is, with EL
i
(y) denoting
the conditional expected loss of exposure i we have:
(30)
Using equations (30) and the systematic loss (17) in the approximation for-
mula (29), we come to a model equation for the unsystematic credit port-
folio loss at a given confidence level, which we can use for calculating
economic capital.
It is important to mention that equation (29) obtained by Gordy is
applicable in the general case where default rates and LGD rates are
correlated.
Numerical examples
To illustrate the influence of unsystematic credit risk as well as the influ-
ence of PD/LGD correlations on the credit portfolio loss at a certain con-
fidence level, we consider a homogeneous portfolio of N exposures of
equal size, which are described by the model functions for p
i
(y) and
^
i
(p
i
)
calibrated for non-investment-grade bonds calibrated in equation (16). In
the following, we calculate the economic capital of our portfolio using for-
mula (29), including unsystematic credit risk.
Figure 6 shows plots of the ratio between the economic capital calcu-
lated according to equation (30) and the capital according to the Vasicek
model (18) used by the IRB approach for different exposure numbers N
and confidence levels. Even for very large N, the IRB capital requirements
underestimate risk, due to the fact that the unsystematic credit risk can be
diversified away, but the additional risk contribution due to PD/LGD cor-
relations remains at a level of up to 35%.
At last, we assume a more realistic example consisting of two classes
of loans, that is, we take 10 investment-grade loans with a PD
1
= 0.14%
of the same exposure size E
1
= 1/20 and a variable number n
2
of non-in-
vestment-grade loans with PD
2
= 4.19% and exposure size E
2
= 1/(2 n
2
),
that is, the total portfolio size is always one. In simple words, half of our
portfolio consists of coarse investment-grade loans (calibrated in equation
(19)), whereas the other half consists of non-investment-grade loans with

2 2 2
L y E x g x y p y dx E x g x y p y dx
i i i i i i i i i i i i
( ) ( ) ( ) ( ) ( )

1
]

11
1

_
,

( )

(
(
(
(

2
1
EL y
i
N
i

VAR L VAR L
y
d
dy
y L y
dL dy
s
s
y N q
unsystema
( ) ( )
( )
( ) ( )
( )

1
2
1
2
1

/
ttic risk adjustment

WWW.RISK.NET

APRIL 2005 RISK 83
5. LGD density distribution
Function g
i
(x
i
| y) plotted over the area y [2; 2] covering 95% of the probability
distribution of the business cycle. One observes the influence of the business
cycle on the distribution of LGDs. In phases of economic expansion y > 0, low
losses x < 0.5 are more probable than high losses x > 0.5. However, in an
unfavourable economy (that is, negative values of y) the distribution tends to
higher LGD rates. The extreme case y can be seen in the lower right
corner, where the losses are always 100% (see worst-case assumption (8)) and
hence the distribution has a peak, that is, lim g
i
(x
i
| y) = (1 x
i
)

y
5
4
3
2
1
0
P
r
o
b
a
b
i
l
i
t
y

d
e
n
s
i
t
y
0
1.0
0.2
0.4
0.6
0.8
x
y
2
0
2
6. Economic capital versus Basel II capital
requirements
1.15
1.20
1.25
1.30
0.90 0.92 0.94 0.96 0.98 1.00
R
a
t
i
o
Confidence level
Ratio of the unsystematic loss (economic capital) including PD/LGD correlations
and the loss according to the Vasicek model with i = 15% and PD
i
= 4.19% as a
function of the confidence level (between 0.9 and one) for N = 10 (red), N = 100
(green) and N = 100,000 (blue). For large N, the diversification effect clearly
reduces the risk. However, the influence of PD/LGD correlations cannot be
diversified away and for confidence levels sufficiently close to one, the
underestimation of risk of the IRB model remains around 35%, independent of
the level of portfolio granularity
In general, calculations show that the capital add-on due to PD/LGD
correlations is higher for portfolios of poorly rated exposures than for in-
vestment-grade portfolios.
Conclusion
An accurate credit portfolio risk model is extremely important, since
credit risk typically constitutes the major contribution to large banks
economic capital. We extended the model of Vasicek used within the
IRB approach to incorporate PD/LGD correlations into the systematic
credit portfolio loss and then generalised the model to incorporate un-
systematic credit risk as well. Our model for correlations between PD
and LGD is based on the beta distribution and was calibrated to histor-
ical data for corporate exposures.
Comparing the capital figures of our model to the IRB capital require-
ments, we conclude that PD/LGD correlations in non-investment-grade
corporate credit portfolios increase the capital requirements by up to 35%
at a 99.9% confidence level (almost) independent of the portfolio gran-
ularity. For lower confidence levels (for example, 90%) the diversification
effect of a portfolio has a major influence on the economic capital. Hence,
we conclude that banks calculating economic capital at a 99.9% confidence
level (like the IRB approach) could approximate their portfolio loss by a
systematic loss distribution of the form (17) capturing the influence of
PD/LGD correlations. Further, for portfolios containing both investment-
grade and non-investment-grade exposures the capital add-on to cover
PD/LGD correlations is lower than 35%, depending on the portfolio mix
and the granularity of the portfolio.
Moreover, a loss distribution of the form (17) with the parameters cal-
ibrated for each asset class could be used in an improved version of the
IRB approach in the near future, instead of function (18) proposed in the
current version of the Basel II Accord (Basel Committee, 2003).
Further, due to the fact that the shape of the Vasicek loss distribution
(18) plotted in figure 2 does not fully represent the credit portfolio risk in-
cluding PD/LGD correlations, pricing models for derivatives such as CDOs
based on the systematic loss distribution (18) can lead to a significant mis-
pricing of tranches.
The advantage of the model we presented is that it is based on exact-
ly the same underlying default model for counterparties (that is, the Mer-
ton model) and the same data input as the advanced IRB capital requirement
formula (that is, PD and LGD estimates per counterparty), and hence is
able to provide a consistent economic capital measure for portfolios that
are not fully diversified and for non-negligible PD/LGD correlations with
very little extra effort. The latter two effects are neglected by the advanced
IRB capital calculation formula.
We showed that the Basel II IRB capital formula might underestimate
risk because PD/LGD correlations are not taken into account. The Basel II
framework contains several conservative assumptions to compensate for
model errors, that is, the usage of a floor of 3 basis points for default rates
of corporate exposures (which is clearly higher than empirical default rates
for AA and AAA exposures) or conservative LGDs within the foundation
IRB approach.
Guido Giese is head of credit and counterparty risk at Vontobel Group in
Zurich. The opinions expressed in this article are the authors and do
not represent the opinion of Vontobel. Email: guido.giese@vontobel.ch
84 RISK APRIL 2005

WWW.RISK.NET
Cutting edge
l
Credit portfolio risk
Altman E, B Brooks, A Resit and A Sironi, 2003
The link between default and recovery rates: theory, empirical evidence and
implications
March, available at www.defaultrisk.com
Basel Committee on Banking Supervision, 2003
The new Basel capital Accord
April
Frye J, 2000a
Collateral damage
Risk April, pages 9194
Frye J, 2000b
Depressing recoveries
Emerging Issues Series, Federal Reserve Bank of Chicago, October
Frye J, 2003
A false sense of security
Risk August, pages 6367
Gordy M, 2000
A comparative anatomy of credit risk models
Journal of Banking and Finance 24, pages 119149
Gordy M, 2003
A risk-factor model foundation for ratings-based bank capital rules
Journal of Financial Intermediation 12(3), pages 199232
Gourieroux C, J-P Laurent and O Scaillet, 2000
Sensitivity analysis of values at risk
Journal of Empirical Finance 7(34), pages 225245
JP Morgan, 1997
CreditMetrics technical document
Martin R and T Wilde, 2002
Unsystematic credit risk
Risk November, pages 123128
Moodys Investor Service, 2000
Default and recovery rates of corporate bond issuers
Saunders A, 1999
Credit risk measurement
John Wiley & Sons
Schuermann T, 2004
What do we know about loss given default?
Forthcoming in Credit Risk Models and Management, second edition, Risk
Books, draft available at www.defaultrisk.com
Vasicek O, 2003
Loan portfolio value
Risk December 2002, pages 160162
Wilde T, 2001a
IRB approach explained
Risk May, pages 8790
Wilde T, 2001b
Probing granularity
Risk August, pages 103106
Wilson T, 1997
Portfolio credit risk
Risk September (part I), pages 111117, and October (part II), pages 5661
REFERENCES
7. Economic capital versus Basel II capital
requirements
1.22
1.24
1.26
1.28
0.1e3 0.1e4 0.1e5
n2
R
a
t
i
o
Ratio of economic capital and Basel II capital requirements as a function of the
number of non-investment-grade loans n
2
. For a low granularity portfolio (n
2
=
50), the add-on to the advanced IRB capital requirements is about 30% and is
decreasing for large numbers of n
2
down to about 20%