März 2004 – No.

34
BANK-FORUM

Sound Calculation for

Probability of Default (PD)
A sound PD calculation is the basis for estimating the credit risk premiums in
profitability accounting and credit risk measurement. Ideally, the PD used in-
ternally and the “official” PD should correspond. The methodology used for
computing PDs being a crucial point in the total bank management philosophy.
By Alexander Dorfmann

The current Basel II discus-
sion focuses on the unexpect-
ed loss and excludes the ex-
pected loss from the risk weigh-
ting functions. As a consequen-
ce, provisions must be built in
for the amount of expected
loss according to internal loss
data. The probability of de-
fault (PD) is now one of the
key parameters in the calcula-
tion of expected losses.
One possible method of PD
estimation is based on histori-
cal data, where estimates are
made per each rating grade.
The key element in PD esti-
mation is the definition of de-
fault. Definitions which trig-
ger earlier defaults will auto-
matically produce higher PDs.
Also, in order to be able to
compare PDs across different
rating systems or for data
pooling, both the rating
processes and the definition
of default have to be identi-
cal.
The calculation of the histor-
ical PD is not very complex.
The PD itself does not include
a loss component but only the
number of defaults within the
given time period.

Number of obligors with rating X

(at the beginning of the given time period)
that defaulted during the given time period
1 year-PD for rating grade X =
Number of all obligors with rating X
at the beginning of the given time period

Basel II requires banks to esti-
mate 1-year PDs based on
long-term averages. This can
be achieved by generating
yearly pseudo-obligor pools,
where each obligor is placed
according to his rating at the
beginning of the year, and
taking the average of the
pools (a minimum of five years
is required in Basel II). In this
way there will be less variation
in the PD estimation from year
to year.

Here is an example with two pools to demonstrate the calculation

2002 2003

Rating Obligors Defaults PD Obligors Defaults PD Avg. PD

AA 100 0 0.0% 120 1 0.8% 0.45%

A 200 1 0.5% 190 2 1.1% 0.77%

BBB 300 3 1.0% 330 4 1.2% 1.11%

BB 400 5 1.3% 420 6 1.4% 1.34%

B 200 8 4.0% 180 8 4.4% 4.21%

CCC 100 15 15.0% 80 14 17.5% 16.11%

1300 32 1320 35

PD = Defaults / Obligors
Avg. PD: (Obligors * PD) + (Obligors * PD) / (Obligors + Obligors )
02 03 02 03

To be continued on Page 2
 Continuation from Page 1
Using this method of pseudo-
pooling, banks can also com-
pute transition probabilities
or cumulated multiyear PDs.
For multiyear estimations, it is
crucial that the pool remains
static or "frozen" with respect
to the obligors in it, so that
the time period is equal for all
the obligors in the respective
Key Factors in PD calculation:
> consistent definition of default (across the data pool)
> perfect data engineering and data pooling solutions
> long-term data time series
> in-time customer rating
Another limitation is given if
PDs are calculated once a year
only (at year end), as changes
in the PDs cannot be foreseen
Corporate portfolio –
Effects of the removal of EL
from the risk weight function
and the change in the
maturity adjustment
LGD 45%
Maturity 2,5 years
pool. In other words, you will
get incorrect – say 5-year PDs,
if some obligors have been in
the pool for five years and
some for only four or three.
One limitation of this me-
thod obviously lies in the size
of the pools. Most banks do
not have large enough credit
in time. A monthly estimation
and comparison of PDs on a
year-to-year basis is therefore
helpful to extend the time
Capital Requirement
Rating PD old
AA- 0,03% 1,18%
BBB 0,29% 4,38%
BB 1,07% 8,01%
B 9,29% 19,27%
portfolios to be able to esti-
mate PDs with adequate gran-
ularity. E.g. 100 obligors in one
single rating grade will enable
PDs to be calculated as a mul-
tiple of 1%, 200 obligors of
0.5%, 1000 obligors of 0.1%
etc. The smaller the number of
obligors, the more volatile the
PD estimation will be.
series and calculate credit risk
and expected losses on current
data.
new difference
1,15% -0,03%
4,28% -0,10%
7,56% -0,45%
15,03% -4,24%