Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

Module II: Key Risks and their Measurement

Section A: Credit Risk

Chapter 3. Techniques for Estimation of Probability of Default (PD)

Dr Arindam Bandyopadhyay

Key Learning outcomes

After studying the chapter and the relevant reading, you should be able to:
 Link credit rating with probability of default (PD)
 Understand the Transition Matrix Approach for estimating PD
 Understand uses of Transition Matrix in risk management
 Estimate marginal PD, one year average PD and cumulative PD from rating
transition history
 Distinguish between marginal PD and cumulative PD
 Differentiate PIT PD from TTC PD
Contents
3.1. Introduction
3.2. Assessment of Probability of Default (PD)
3.3. PD estimation through rating Transition Matrix
3.4. Marginal PD vs. Cumulative PD
3.5. Benefits of Rating Migration Study
3.6. Pooled PD Estimation
3.7. PD Estimation from Loss Data
3.8. Point in Time vs. Through the Cycle PD
3.9. Key Learning Questions

3.1. Introduction
In order to measure the credit risk capital, probabilities of default are to be estimated by
banks applying their internal credit ratings. The correspondence between rating

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

notches and probabilities of default can enable a bank to better compare their assets. A
rating can be very useful indicator of risk if it can place the borrowers in the correct
order with regard to their individual PDs. This is why cardinal ranking of risk can assist
an FI manager to conduct objective assessment of credit proposal than the ordinal
ranking which is subjective in nature. In this lesson chapter, various techniques for
estimating probability of default (PD) and its usage has been illustrated with numerical
examples.
3.2. Assessment of Probability of Default (PD)
The objective is to forecast whether a customer or a loan will default in the next year.
This implies predicting the future outcome of a random experiment (like throwing a
dice). In the Basel prescription, capital adequacy of a bank is to be determined by PDs.
Therefore, it is important to derive a correct estimate of probabilities of default.
3.3. PD Estimation through Rating Transition Matrix
The Transition Matrix provides the profile of credit quality changes or migrations that
have taken place for the selected credit portfolio between any two years that are
selected. The Transition Matrix is a summary of how all the rated borrower accounts in
the user's credit portfolio have migrated (within various standard account categories as
well as to default or NPA category) between the selected two years.
For the Transition Matrix to be generated, at least two years rating data should be
available in the Model. If ratings have been generated for borrower accounts for only
one year, the Transition Matrix will not be generated and the appropriate message will
be displayed when the user tries to process this report.
Here we are mainly talking about discrete transition matrices. The traditional transition
matrices provided by rating agencies are in discrete time, typically with a 1-year
horizon. Information at only two dates for each year of data is necessary to calculate
such a transition matrix. As a first step, we start by doing mortality rate analysis of
yearly cohorts of companies for at least 2 years to find the number of firms in each
rating class in each cohort moving towards default category (D). Each cohort comprises
of all the companies which have a rating outstanding at the start of the cohort year.
From these cohorts, we calculate year-wise default probabilities for different rating
grades and for different industries. Say there are Fi,D number of firms migrating from ith
rating to Default category out of Ni number of firms in the ith rating grade (or industry)
over a one-year period, where the subscript i represents the rating grade (or industry)
at the start of the period and the subscript D represents Default. The one-year
probability (PD) of the ith rating grade (or industry) is estimated by counting the
𝐹𝑖,𝐷
frequencies: . These frequencies can be obtained from yearly cohort-study (grade to
𝑁𝑖
grade movement). The rating cohorts can be constructed in Excel by PIVOT tables, using
rating data of a clients over years.

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

The average one-year default probability for the ith rating grade or industry (PDi) is
obtained by weighted average, where the weights are the number of firms in the ith
rating class (or industry) in a particular year divided by the total number of firms in all
the years.
𝑡
𝐹𝑖,𝐷
𝑃𝐷 = ∑𝑇𝑡=1 𝑤𝑖𝑡 Equation 3.1
𝑁𝑖𝑡

where wi is the weight representing the relative importance of a given year, i.e. relative
number of accounts in each grade over time period (t). The weight factor adjusts year
wise variability in default rates.
𝑁𝑖𝑡
𝑤𝑖 = ∑𝑇 𝑡
𝑡=1 𝑁𝑖

For example, let’s consider during 2012-13, that out of 500 corporate borrowers from
“A” grade, 5 borrowers have migrated to default; and in 2013-14, 8 out of 480 have
moved to default category and finally during 2014-15, 15 out of 440 borrowers have
gone to default. Therefore, the yearly marginal default rates in the first year migration
(MPD1) would be: 5/500=1% in 2012-13. Similarly, MPDs in other years would be:
MPD2=8/480=1.67% in FY 2013-14 & MPD3=15/440=3.41%. The relative number of
borrowers’ weight in respective years would be:
w1=500/(500+480+440)=500/1420=35.21%;
Similarly, w2=480/(500+480+440)=480/1420=33.80% &
w3=440/1420=30.99%.Thus,
Probability of Default (PD) for the entire time period will be=
w1×MPD1+w2×MPD2+w3×MPD3=1%×35.21%+1.67%×33.80%+3.41%×30.99%=
1.97%
Alternatively, one can also estimate PD by simply adding all the default counts and
divide it by the total number of accounts in that grade over all the years:
5+8+15 28
∴ PD=500+480+440 =1420=1.97%

We will obtain the same borrower weighted PD.

This average one year PD over a long run cycle is considered as a stable through the
cycle Basel IRB PD which can be used for estimation of credit risk weighted assets.
However, for IFRS 9 accounting purpose, the 12 month PD is estimated for a shorter
horizon (3-5 years average) and is further linked with macro-economic conditions to
generate forward looking PDs. This PD has to be point in time in nature that will finally
be used for calculation of expected credit loss (ECL).
In the following Table, we present a one-year average transition matrix for the entire
sample period (1981 to 2014). We find that as the credit quality worsens (i.e. rating
grades decline) the default probability (PD) increases. Also note that that the rating

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

stability declines (AAA to AAA stability is 87.03%, where BB to BB next year stability is
only 76.62%) as the credit quality worsens. Further, the all the column sum in the
matrix is=100%.
Table 3.1. Standard & Poor’s data, 1981-2014, all global corporate obligors
(Figures in % unit)

From/To AAA AA A BBB BB B CCC/C D NR

AAA 87.03 9.03 0.54 0.05 0.08 0.03 0.05 0.00 3.19
AA 0.54 86.53 8.14 0.54 0.06 0.07 0.02 0.02 4.07
A 0.03 1.83 87.55 5.38 0.35 0.14 0.02 0.07 4.64
BBB 0.01 0.11 3.58 85.44 3.75 0.56 0.13 0.20 6.23
BB 0.01 0.03 0.14 5.16 76.62 6.96 0.66 0.76 9.64
B 0.00 0.03 0.10 0.21 5.40 74.12 4.37 3.88 11.89
- CCC/C 0.00 0.00 0.14 0.22 0.65 13.26 43.85 26.38 15.49

Note: NR: is not rated or rating withdrawn %.

3.4. Marginal PD vs. Cumulative PD
The marginal PD represents the default rates in a particular year. This may change year
to year and captures the most recent information about changing macro-economic
factors. We have seen that these yearly default rates can be utilized to estimate long run
probability of default (PD).
The cumulative probability of default (CPD) gives us the default path for the entire
lifetime of the loan. It captures how default risk increases every year over the entire
time horizon (say 5 years on 10 years). This can also be useful for estimating spread for
long term loans that may be adjusted with the loan pricing.
The difference between marginal default rates (or PD) and cumulative probability of
default (CPD) has been presented in the following chart. While marginal PD focuses on
one year estimate of risk, the cumulative PD provides lifetime (of the loan) estimate of
risk. The marginal PDs: p1, p2, …p10 can be estimated from the difference between two
subsequent years’ cumulative PDs.
Chart 3.1-Marginal PD vs. Cumulative PD

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

3.5. Benefits of Rating Migration Study:

Rating migration study, mainly on sub-portfolios (industry, region etc.) enables a bank
to identify risky and stable areas of the loan portfolio. It provides information about the
movement of borrowers from one rating category to another at various sub-portfolios
(pools of credit assets) over time. This can be used as an effective monitoring tool to
track the rating behavior of various clients across industries/regions. Migration study is
beneficial for risk managers since it facilitates the decision taking on credit quality
related issue, relates pricing to factor in migration risks, facilitates active portfolio
management, provides inputs for estimation of provisioning amount and computation
of regulatory/economic capital needed.
3.6. Pooled PD Estimation
A bank can also estimate probability of default from various loan pools. The following
Table 3.2. shows the Rupee amounts of outstanding loans and corresponding default
amounts for every year over the past five years. Note that the default figures in Rs. lakh,
while the loan outstanding figures are in Rs. crore.
The marginal default rates (MPD) for each rating grade are estimated by dividing the
annual default amount by the outstanding amount in every year. The annual probability
of default (PD) is the simple average of annual default rates (MPDs). It is also termed as
marginal mortality rate (p1, p2,…., p5), or the probability of the loan defaulting in each
year. Since it is estimated through exposure ratios, PD value is already exposure
weighted and hence is a stable number.
Pooled PD is normally used for calculation of retail risk where homogenous pools are
generated for better segmentation of PD. Following the above approach, a bank can also
compute PDs for several retail pools in terms of common risk characteristics e.g. score-
wise, product wise (housing loan pool, agriculture loan pool, car loan pool etc.), days
past due (DPD), months on book, region wise etc.
The cumulative probability default (CPD) at the end of 5 year is estimated using survival
analysis from the annual mortality rates.
Therefore, CPD5=1-{(1-p1)(1-p2)(1-p3)(1-p4)(1-p5)}. Equation 3.2
For example, suppose marginal probability of default in year 1 of a borrower is 0.05 and
marginal probability of default in year 2 is 0.07, the survival probability of the borrower
at the end of period 2 is
=(1-p1)×(1-p2)=(1-0.05)(1-0.07)=(0.95)(0.93)=0.8835.
Thus, CPD2=1-{(0.95)(0.93)}=0.1165.
So, there is an 11.65 percent probability of default over 2 year. However, it assumes
each year is independent and in between there will not be any further migration.

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

Table 3.2.-Pooled PD illustration

Years after sanction
Loan 2- 3- 4- 5-
1-year
Type years years years years
Annual default
A-rated 0.06 0.40 1.60 3.50 3.60
(Rs. millions)
Outstanding
200.00 190.00 186.00 182.00 176.00
(Rs. billions)
MPD% 0.000 0.002 0.009 0.019 0.020
PD% 0.010
Std-PD% 0.01
CPD% 0.050
BBB- Annual default
0.50 3.00 5.00 6.00 8.00
rated (Rs. millions)
Outstanding
200.00 188.00 186.00 178.00 170.00
(Rs. billions)
MPD% 0.00 0.02 0.03 0.03 0.05
PD% 0.025
Std-PD% 0.02
CPD% 0.120
Annual default
CCC-rated 4.00 8.00 12.00 12.00 16.00
(Rs. millions)
Outstanding
200.00 194.00 180.00 170.00 158.00
(Rs. billions)
MPD% 0.02 0.04 0.07 0.07 0.10
PD% 0.060
Std-PD% 0.03
CPD% 0.267
Note: for illustration purpose. The probabilities are in percentage term.

3.7. PD Estimation from Loss Data

As an alternate approach, probability of default can also be extracted from yearly
movements of non-performing assets. This method has been illustrated with following

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

example. Consider the loss information in Table no 3.3. This write-off information can
be obtained from the bank’s annual reports. The loss is written in percentage terms to
reduce the effect of the changing size of the portfolio. This historical expected loss (EL)
of the entire bank portfolio (say corporate loans) is simply the average of the losses.
Table 3.3.-Estimation of PD from Loss Data
Financial Year Assets Lent (Rs. Write-offs (Rs. Loss Rate (%)
Billion) Billion)
2007 240 0.6 0.25%
2008 250 1.1 0.44%
2009 270 4.5 1.67%
2010 290 8.6 2.97%
2011 300 4.5 1.50%
2012 320 3.4 1.06%
2013 350 3.2 0.91%
2014 370 4.5 1.22%
2015 385 5.6 1.45%
2016 390 8.5 2.18%
2017 400 18.6 4.65%
Expected Loss (EL%) 1.66%
LGD% 65% (assumed)
Pooled PD% 2.55%

The estimated EL value is 1.66%. If we assume that the loss given default (LGD) for the
entire pool is 65%, then average probability of default for the loans in this portfolio is
2.56% (EL/LGD=1.66%/65%=2.55%). The bank can assume that the average
probability of default of any loan in this portfolio is 2.55%.

3.8. Point in Time (PIT) vs. Through-the-Cycle (TTC) PD:

There are two concepts regarding estimation of one year PD, point in time (PIT) and
through the cycle (TTC) approach. Banks generally tend to focus more narrowly on
current conditions in setting ratings than do public rating agencies (of agencies like
S&P, Moody’s etc.). This suggests that many bank rating systems may conform more
closely to a PIT philosophy as they give more importance to the condition of latest
balance sheet of a borrower.

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

A point-in-time (PIT) normally groups obligors according to one-period-ahead

predicted default frequencies. It assesses the likelihood of default over a future period,
most often the period one year from now. An accurate PIT PD describes an expectation
of the future and incorporates all idiosyncratic effects and all relevant cyclical changes.
An obligor’s PIT PD can be expected to change rapidly as its economic prospects change.
TTC PDs, in contrast to PIT PDs, reflect circumstances anticipated over an extremely
long period in which effects of the credit cycle would average close to zero. The Basel
Committee on Banking Supervision (BCBS) recommends through the cycle (TTC)
estimates of one year forward PD for regulatory estimation of credit risk capital. This is
because the TTC PD provides a more stable outlook about the future risk of the
borrower. Banks need to keep rating history (normally for 10 years) to estimate Basel
compliant stable PDs. It is worthwhile to mention that a bank can use rating transition
matrix to monitor their credit portfolio. This enables a credit manager to track the
slippage of assets and derive early warning signals.
The below chart 3.2 indicates pattern of TTC PD, PIT PD and Hybrid PD.
Chart 3.2. PIT vs. Hybrid vs. TTC PD

Graph A is point in time PD since it varies the most with changing macroeconomic
conditions over time. Graph C is a through the cycle (TTC) PD as the TTC PD remains
perfectly stable over the time horizon. Graph B is hybrid PD since it is a mix of both TTC
and PIT pattern. It varies less than the PIT PD but more than the TTC PD since it
considers macro factors to a limited extent.
3.9. Key Learning Questions:
1. Elaborate how Transition Matrix can be used to limit migration risk?
2. How will you estimate PD from NPA movements?
References:
1. Bandyopadhyay, A. (2016), “Managing Portfolio Credit Risk in Banks”, Cambridge
University Press. Chapter 3.

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Course: Risk Management (Module II: Key Risks and their Measurement) NIBM, Pune

2. Joseph, C (2013), Advanced Credit Risk Analysis and Management, Wiley Finance,
Chapter 10.

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