Guidelines on PD modelling

FONDI BESA
Approved by supervisory council

Decision no 316, date 24.02.2020

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Guidelines on PD modelling | Content

Content

Content 1
1. Introduction to PD model 2
2. Methodology for PD model 3
3. Data preparation 11
4. Assisted tools Error! Bookmark not
defined.

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1. Introduction
1.1 Scope of the guidelines

The purpose of this document is to guide the entity in modelling the probability of default (PD) in
line with IFRS 9 principles.

The entity shall assess probability of default at each reporting date considering historical default
rates and prospective macroeconomic adjustments. The entity will assess the PDs at the end of
each quarter considering updated history of defaults.

The entity shall assess the Macro-Economic factor overlay annually considering the most recent
macroeconomic data and forecasts in line with A.5 Guideline on Macro-modelling.

1.2 Main definitions

Definitions in these guidelines are consistent with those provided in the Impairment Policy
document.

1.3 Responsibilities

The Head of the Risk Management Department is the person responsible for preparation or
review of these guidelines and propose changes for approval of the Executive Director.

1.5 Changes and updates

These guidelines are subject to change. The new developments and innovations will be
incorporated in these guidelines, at the time of approval.

1.6 Effective date

These guidelines are effective since 1st of January 2018, in the context of IFRS 9 adoption.

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 Guidelines on PD modelling | 2. Methodology for PD model

2. Methodology for PD model

2.1 Mathematical background to the PD model

For the purpose of modelling lifetime PDs the methodology of migration matrices is suggested, as
so far, this is the most common methodological approach used for IFRS9 PD modelling for
segments covered with rating models.

Migration matrices methodology is based on the theory of Markov chains. Markov chain is a
discrete random process containing a finite set of states 𝐹 and including probabilities governing
this process between individual states. This means that the process begins in a certain state 𝑖 and
in the next step it moves to the state 𝑗 with the transition probability 𝑝𝑖𝑗. It is assumed that
described process is characterized by the Markovian property, which means that the probability of
the process being in a certain state in time 𝑡 + 1 depends only on the state of the process in time
𝑡; it is independent of any state preceding time 𝑡.
The Markov chain model to build a PD term structure requires plotting of transition matrices till
the lifetime of the asset. The chain is overlayed with credit index (representation of the economic
conditions of that particular year) to derive forward-looking PDs. The transition matrices are then
multiplied to compute the cumulative or lifetime PD over particular maturities. The matrix
multiplication traces movement of a performing loan to default over a period of time.

Putting that in the context of IFRS 9 lifetime PD modelling this would mean that if the client is
rated 𝑖 at time 𝑡, then the probability of being graded 𝑗 in the time 𝑡 + 1 is equal to 𝑝𝑖,𝑗 and is
independent from any rating grades the client had before time 𝑡.

During the transition period particular client may default, migrate to any of existing rating classes
or can be repaid. Since repayment is not treated as an additional absorbing state in transition
matrices, in order to account for repayments in survival rate exposures replayed are distributed
among non-defaulted transitions (repayment adjustment).
Assuming that transition probabilities remain constant over time based on migration matrix 𝑀 the
cumulative multi-year transition probabilities can be calculated by raising matrix 𝑀 to a power.
This means that cumulative transition probabilities for 𝑁 years horizon are obtained as 𝑀𝑁.

The migration matrices model looks at migration between different risk grades and requires the
Entity to apply a risk grading system where the rating grade is a major risk determinant. This
model, aims to capture flow from a certain risk grade to default, assuming that PD increases as
the risk grade deteriorates.
Formally, let {𝑋𝑛} be a sequence of random variables, then the property described above can be
written as:
(𝑋𝑡+1 = 𝑗|𝑋0 = 𝑖0, … , 𝑋𝑡−1 = 𝑖𝑡−1, 𝑋𝑡 = 𝑖) = (𝑋𝑡+1 = 𝑗|𝑋𝑡 = 𝑖) = 𝑝𝑖,

Let’s assume the rating system with 𝑛 − 1 rating grades. During the transition period particular
client may default, migrate to any of existing rating classes or can be repaid. Since repayment is
not treated as an additional absorbing state in transition matrices, in order to account for
repayments in survival rate exposures repaid are distributed among non-defaulted transitions
(repayment adjustment). Then the transition matrix 𝑀 would be given as:

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 Guidelines on PD modelling | 2. Methodology for PD model

or equivalently

The transition matrix 𝑀 is described by the following characteristics:

 Each 𝑚𝑖,𝑗 represents the unadjusted probability of an exposure migrating
from rating 𝑖 to rating 𝑗 or to default if 𝑗 = 𝑛,
 Each , represents the probability of an exposure from a specific rating being repaid.
Repaid
exposures are not used as a state in transition matrices, hence they are
distributed between transition probabilities to specific ratings according to
their relative share in non-default transitions. This method produces results
equivalent to using repayment as another absorbing state,
 Each cell of matrix 𝑀 represents the repayment adjusted transition probability, hence 0
≤ 𝑝𝑖,𝑗 ≤ 1,
 Since ,the sum of repayment adjusted transition probabilities in each
row
equals to 1, therefore ,
 The last column represents the probability of default for each of 𝑛 − 1 rating grades,
 The last row represents the assumption of default as the absorbing state,
which means that once the default is achieved it is not possible to move back
to the previous states, hence 𝑝𝑛,𝑗 = 0 for 𝑗 < 𝑛 and 𝑝𝑛,𝑗 = 1 for 𝑗 = 𝑛.

Assuming that transition probabilities remain constant over time based on migration
matrix 𝑀 the cumulative multi-year transition probabilities can be calculated by raising
matrix 𝑀 to a power. This means that cumulative transition probabilities for 𝑁 years
horizon are obtained as 𝑀𝑁.
The last column of matrix 𝑀𝑁 demonstrates cumulative PDs for each rating grade in 𝑁
years horizon. Based on matrix 𝑀 raised to powers 1, … , 𝑁 the matrix 𝐶𝑛×𝑁 of cumulative
PDs is constructed:

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Where p(𝑘) denotes the element of 𝑀𝑘 matrix in the last 𝑛-th column and 𝑖-th row.
𝑖,𝑛

Expected loss formula requires values of conditional PDs for future years. This means
that cumulative PDs obtained by raising migration matrix to powers corresponding to
consecutive years after reporting date need to be transformed into conditional PDs.
This is done via Bayes formula as:

Where:
𝑃𝐷𝑖, – conditional PD for 𝑖-th rating grade in 𝑡-th year after reporting date,

–cumulative PD for 𝑖-th rating grade in 𝑡-th year after reporting date,

– cumulative probability for 𝑖-th rating grade of surviving as non-default up to year 𝑡.

2.2 Key assumptions

The lifetime PD model is based on the following key assumptions:

 Contracts are grouped by district

Contracts are grouped by district, which represents a key driver of the credit risk.
 Lifetime PD is calculated based on the number of contracts in each district

Contract migration between rating grades assumed as ratings are assigned on a

the client level, however because of the nature of clients (small businesses or
retail customers), one clients holds usually one loan contract within the same
category. Where the contract number is not sufficient to provide statistical data
the Entity will apply the PD parameter of another district showing similar
economic characteristics.
 Rating grade is a major risk determinant

Each non-defaulted client is rated on a monthly basis considering updated

information on past due and delinquencies with the Entity in line with the
Regulatory provisions.

 The rating grade worsens

Rating grades reflects the level of client risk. The worse the grade the higher PD
should be assigned to the client.

 Default is the absorbing state

This means that for the purpose of PD estimation migration from default state to
any non-defaulted rating class is not allowed. This is equivalent of no cure events
incorporated in PD estimation – cures are usually modelled as separate parameter
or are included in LGD estimates as they might be considered as the result of
work-out process.

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2.3 Calculating lifetime PD

Step 1: Calculation of average migration matrix for defined time horizon

1a. Choice of time horizon over which the migration matrices are to be averaged

The time horizon over which PDs should be estimated should ensure relevant number of
observations as well as reflect the current risk of the portfolio. The Entity may consider
a time horizon of 24 months to ensure that the average migrations explained in the
following steps consider the recent credit risk trends and eliminates from the projections
any older trend which is not representative of the current risk position of the loans
portfolio.

1b. Calculation of monthly migration matrix by number of clients over the time horizon defined
in 1a Average monthly migration matrix is calculated with the following formula:

Where:
𝑥𝑖, – element in 𝑖-th row and 𝑗-th column of monthly migration matrix 𝑋,

𝑘𝑖,𝑗 – the number of clients who at month 𝑡 were in 𝑖-th rating class and
migrated to 𝑗-th rating class in one month horizon,
𝑇 – maximum number of months to be included in the migration matrix.

1c. Calculation of average percentage migration matrix based on matrix in 1b

Average percentage matrix 𝑃 = {𝑝i,j}𝑛×𝑛 reflects the probability of migration from rating 𝑖
to rating 𝑗 in one month horizon. Element , is given as:

Where:
𝑝𝑖, - element in 𝑖-th row and 𝑗-th column of monthly percentage migration matrix 𝑃,

𝑥𝑖, – element in 𝑖-th row and 𝑗-th column of monthly migration matrix 𝑋,
𝑟𝑖 – number of clients in 𝑖-th rating class that repaid all obligations during the time period,
𝑛 – number of columns (as well as rows) of migration matrix 𝑋.

1d. Adjustment for clients who repaid all obligations during the period
Given the vector 𝑃𝑅 = {𝑝𝑟𝑖}n×1 of percentage of clients who repaid all obligations during the
time period, where: the adjustment of the average percentage matrix 𝑃
from 1c is performed.
The resulting matrix is 𝑀 = {𝑚i,j}nxn and it is calculated as follows:

Where:

𝑝𝑖, - element in 𝑖-th row and 𝑗-th column of monthly percentage migration matrix 𝑃,

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 Guidelines on PD modelling | 2. Methodology for PD model

𝑝𝑟𝑖,j – 𝑖-th element of repayment vector 𝑃𝑅

The last column of obtained percentage migration matrix is monthly PD for each rating
class.

Step 2: Calculation of yearly average migration matrix

 Given monthly adjusted percentage matrix yearly percentage

migration matrix 𝑌𝑛×𝑛 is calculated by raising to 12th power:

 Yearly percentage migration matrix 𝑌 is used further in step 5 for calculation of lifetime
PD curves.

Step 3: Calculation of lifetime PDs based on 1 year migration matrix

3a. Calculation of migration matrices for following years

 Based on 1 year percentage migration matrix 𝑌 obtained in step 4 migration
matrices for following years are calculated by raising matrix 𝑌 to a 𝑡th power.
𝑌𝑡 represents probabilities of migration from 𝑖- th to 𝑗-rating class in 𝑡 years
horizon from the reporting date.

2b. Cumulative multi-year PD

The last columns of matrices 𝑌𝑡 from 5a are the cumulative PDs for consecutive
years. This means that:

 probabilities of default in 1 year horizon from the reporting date are in the 𝑛-th
column of matrix

 probabilities of default in 2 years horizon from the reporting date are in the 𝑛-th
column of matrix

 probabilities of default in 3 years horizon from the reporting date are in the 𝑛-th
column of matrix and so on.
As the final result of this step the array 𝐶𝑛×𝑇 of cumulative PDs for each of 𝑛 rating classes
in 𝑁 consecutive years after reporting date is created as:

In the plot below obtained values of cumulative PDs for each rating grade are presented.
Discrepancies of PD values between rating classes is clearly visible through 10 years after
reporting date considered.

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3c. Survival function

Based on cumulative multi-year PD array 𝐶={ci,t}nxN from 5b the survival array S = {si,t}
nxN is calculated as:

Each 𝑠𝑖, element of array 𝑆 represents the cumulative survival rate up to 𝑡-th year after
reporting date given that at the reporting date the client has 𝑖-th rating grade.

3d. Conditional PD(t)

The expected loss formula requires conditional PDs, hence based on the cumulative PDs
array 𝐶 from 5b and survival array from 5c an array of conditional PDs is
calculated as:

Each element 𝑝𝑑𝑖, represents the probability of default event in 12-month horizon exactly
at time 𝑡 after reporting date, given that the client survived up to time 𝑡 and at the
reporting date was graded 𝑖-th rating.

3e. Marginal PD(t)

Marginal PD for year t is assessed as the difference between Cumulative PD for year t and
the cumulative PD for year t-1.

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3. Macroeconomic
adjustment for lifetime PD
IFRS9 requires that expected loss estimation should be among others forward
looking. This means in particular that PD parameters should reflect client risk not
only as of reporting date but also they should take into account the expectations of
future market conditions. In order to achieve those forward looking PD estimates
econometric models describing dependencies between macroeconomic factors and
historical default rates will be developed and based on them the scaling factors to be
incorporated into lifetime PD estimates will be derived. Macroeconomic PD models
are separate deliverable, hence they are out of scope of this memorandum. They
will be presented in another document.

Assuming that scaling factors are given, the algorithm for incorporation of them into
lifetime PD estimates is as follows:

6a. Input values - 1 year migration matrix and scaling factors from macro PD model
Macroeconomic adjustment is performed on 1 year migration matrix. The reason
for that is the change of transition probabilities to default state entails the change
in all other transition probabilities. Therefore, as the base for macroeconomic
adjustment 1 year migration matrix (adjusted for calibrated PDs) 𝑌 obtained in
step 4 is used.

6b. Macroeconomic adjustment of 1 year migration matrix for the following years
Macroeconomic forecasts for future years will differ; hence scaling factors for
consecutive years will be different. Therefore, migration matrix 𝑌 has to be
adjusted separately for each year.

The macroeconomic adjustment is performed in a similar way as adjustment for

calibrated PDs, i.e.: Given the vector of macroeconomic scaling factors 𝑆𝐹 =
{𝑠𝑓𝑡}×1 the yearly PDs (last column of matrix
𝑌) is multiplied by the scaling factor corresponding to the certain year. All other cells of the
matrix
(excluding 𝑛-th row and 𝑛-th column) are proportionally adjusted so that the
sum of each row is equal to 1.

The resulting matrix is calculated as follows:

Where:

– element in 𝑖-th row and 𝑗-th column of macro adjusted yearly

migration matrix for the 𝑡-th year,
𝑦𝑖, – element in 𝑖-th row and 𝑗-th column of yearly percentage migration
matrix 𝑌 (adjusted for calibrated PDs),
𝑦𝑖, – element in 𝑖-th row and 𝑛-th column of yearly percentage migration matrix
𝑌; this is PD for 𝑖-th rating class after PD calibration,

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(𝑚) – 𝑖-th element PD vector of calibrated monthly PDs (𝑚).

𝑖

In this step macro-adjusted yearly migration matrices 𝑌̃𝑡 are created.

Based on them cumulative migration matrices for consecutive years are
calculated.

6c. Matrix multiplication to obtain cumulative PDs in following years

Given 𝑁 macro-adjusted migration matrices from 6b 𝑁 cumulative migration
matrices (of which last column corresponds to cumulative PDs) are calculated.
Cumulative migration matrices 𝑍𝑡 are obtained by multiplication of consecutive
yearly migration matrices as follows:

Based on obtained matrices 𝑍𝑡 conditional PDs adjusted for macroeconomic

expectations are calculated with the same procedure as presented in steps
from 5b Cumulative multi-year PD to 5d Conditional PD(t), assuming that in
step 5b instead of matrices 𝑌𝑡 matrices 𝑍𝑡 are used.

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3. Data preparation
FONDI BESA analyses a snapshot of the end of month loan portfolios for a period of 24 months.
The monthly loan portfolios are combined to obtain a combined database.

The loan portfolios include details such as contract numbers, client ID, contract start date,
contract maturity date, district, disbursed amount / approved amount in contract currency and
Lek equivalent, on balance sheet exposure in contract currency and Lek equivalent, unused credit
limits, regulatory risk classification, delay status (in past due or not in past due) etc.

The Entity performs several validation checks to ensure that contract numbers pertained to a
single client, PD segment and had the same start and maturity date. Major errors in the database
were reported and corrected before the study.

Risk classes are assigned to each loan in 24 months database and the data were sorted in the
following order to trace the status in the subsequent month t+1

Contracts A to Z
Reporting months Oldest to newest

Contracts leaving the database are analyzed and assigned to one of the following:
- Default status, if consistent with the definition of default.
- Last reporting date, if the reporting date was equal to last observation month.
- Assumed as repaid, if did not fall in none of the above status.

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