Transition Probability Matrix Methodology for Incremental Risk Charge

Yavin, Tzahi and Zhang, Hu and Wang, Eugene and Clayton, Michael (2011): Transition Probability Matrix Methodology for Incremental Risk Charge.

Abstract

As part of Basel II's incremental risk charge (IRC) methodology, this paper summarizes our extensive investigations of constructing transition probability matrices (TPMs) for unsecuritized credit products in the trading book. The objective is to create monthly or quarterly TPMs with predefined sectors and ratings that are consistent with the bank's Basel PDs. Constructing a TPM is not a unique process. We highlight various aspects of three types of uncertainties embedded in different construction methods: 1) the available historical data and the bank's rating philosophy; 2) the merger of one-year Basel PD and the chosen Moody's TPMs; and 3) deriving a monthly or quarterly TPM when the generator matrix does not exist. Given the fact that TPMs and specifically their PDs are the most important parameters in IRC, it is our view that banks may need to make discretionary choices regarding their methodology, with uncertainties well understood and managed.

• Item Type: MPRA Paper
• Language: English
• Keywords: Basel II, trading book, incremental risk charge, default probability, default correlation, transition probability matrix, generator matrix, credit portfolio
• Subjects: C - Mathematical and Quantitative Methods > C0 - General > C02 - Mathematical Methods; G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation; G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages

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