Reliable loss prediction requires both robust estimation methods and accurate data. This article presents a way to leverage ratings agency data that can provide greater flexibility and stability of results in simulation-based estimates of future portfolio losses.

Based on a simple behavioral model that quantifies the structural relationships in historical default frequencies and transition rates for different ratings, (1) this technique leads analysts to hypothetical transition matrices for portfolio loss simulations that preserve the basic relationships observed in the historical transition and default rates reported by the ratings agencies, allowing for unlimited sampling. The matrices can also be linked to macroeconomic factors to mimic the dynamics of credit cycles and economic shocks, allowing for richer descriptions of plausible future scenarios and what-if scenario analysis that goes beyond the limitations of historical data.

The Basel II capital adequacy framework provides strong incentive for financial institutions to use internal risk management systems to measure risk and determine sufficient regulatory and economic risk capital. While commercial risk measurement tools can be used as part of an overall solution, institutions must tailor them to their own portfolio specifications. Further, some of the development and implementation of the new systems will fall to their own risk management teams

In many cases, whether they use commercial models or internal methodologies, analysts continue to rely on data from the major ratings agencies for default rates, ratings migration rates, and other key statistics. Despite recurring and somewhat troubling issues regarding the meaning and consistency of ratings, regulators tend to be more accepting of methodologies based on agency data because of the agencies' long and well-documented ratings histories. This data may indeed be deeper and may conform better to an accepted standard than banks' own internal ratings histories, yet the depth of agency data generally falls short of what's needed for the Monte Carlo-based economic risk capital estimation techniques in widespread use today.

The Shortcomings

The simplest portfolio loss model assumes that ratings transition probabilities are stable across obligor types and across the business cycle, and that a single set of average historical ratings transition and default rates is all that's needed to characterize potential future losses. However, there is ample evidence that credit migration and the ratings process depend on a number of factors, such as the state of the economy-for example, the probability of downgrades and defaults is greater in a downturn than in an upturn. Moreover, historical data is volatile; thus, the average-rate approach will understate potential tail loss--the very thing we want to measure with precision. A slightly more sophisticated alternative is to use observed annual historical-rating transition rates as a sample from which to draw plausible future credit migration scenarios to simulate the forward loss distribution. The main drawback of this method is the small number of historical-rating scenarios on which to draw. Accurate Monte Carlo simulations for large portfolios usually require tens--or even up to hundreds of thousands--of random draws. However, because historical scenarios number only in the tens, the simulated loss distribution will tend to be lumpy as tail losses bunch up around the worst year from the historical period. Clearly, this problem cannot be overcome by increasing the number of Monte Carlo simulations.