Empirical estimation of default and asset correlation of large corporates and banks in India

Bandyopadhyay, Arindam and Ganguly, Sonali (2011): Empirical estimation of default and asset correlation of large corporates and banks in India.

Abstract

Estimation of default and asset correlation is crucial for banks to manage and measure portfolio credit risk. This would require studying the risk profile of the banks’ entire credit portfolio and developing the appropriate methodology for the estimation of default dependence. Measurement and management of correlation risk in the credit portfolio of banks has also become an important area of concern for bank regulators worldwide. The BCBS (2006) has specifically included an asset correlation factor in the computation of credit risk capital requirement by banks adopting the Internal Ratings Based Approach. We estimate default correlation in the credit portfolio of banks. These correlation estimates will help the regulator in India to understand the linkage between bank’s portfolio default risks with the systematic factors. We also derive default and asset correlations of Indian corporate and compare it with global scenario. The work tries to find the relationship of the correlation to the default probability as specified by the Basel committee. The findings of this paper could be used further in estimating portfolio credit risk, economic capital and risk adjusted returns on economic capital for large corporate exposures of banks.

• Item Type: MPRA Paper
• Language: English
• Keywords: Default Correlation, Asset Correlation, Credit Portfolio Risk
• Subjects: G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C15 - Statistical Simulation Methods: General; G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages

References

Bandyopadhyay, A. and Chherawala, T. and Saha A. (2007), “Calibrating asset correlation for Indian corporate exposures: Implications for regulatory capital”, The Journal of Risk Finance, Vol. 8, No. 4, pp. 330-348.

Basel Committee on Banking Supervision (BCBS), (2006), International Convergence of capital Measurement and Capital Standards: A Revised Framework, Publication No. 128, Bank for International Settlements, Basel, June.

Bluhm, C. and L. Overbeck, (2003), “Systematic risk in homogeneous credit portfolios”; in: Credit Risk; Measurement, Evaluation and Management” in; G. Bol et al (eds), Contributions to Economics (Heidelberg, Physica: Verlag/Springer).

Bluhm, C. and L. Overbeck, (2007), “Explaining the correlation in Basel II: Derivation and evaluation”, in Michael Ong (eds), The Basel Handbook: A guide for financial practitioners (RISK books).

Credit Metrics. (1997), Technical document, JP Morgan.

Crouhy, M. and Galai, D. and Mark, R. (2000), “A comparative analysis of current credit risk models”, Journal of Banking & Finance, Vol. 24, Nos. 1-2, , pp. 59-117.

Frey, R. and McNeil, A. J. and Nyfeler, M. A. (2001), “Modelling dependent defaults: Asset correlations are not enough!” Working paper, ETH Zurich.

Gordy, M. B. (2000), “A comparative anatomy of credit risk models”, Journal of Banking & Finance, Vol. 24, issues 1-2, pp. 119-149.

Lopez, J. A. (2004), “The empirical relationship between average asset correlation, firm probability of default, and asset size”, Journal of Financial Intermediation, Vol. 13, No. 2, pp. 265-283.

Lucas, D. J. (1995), “Default correlation and credit analysis”, Journal of Fixed Income, Vol. 4, No. 4, pp. 76-87.

Merton, R. (1974), “On the pricing of corporate debt: The risk structure of interest rates”, Journal of Finance, Vol. 29, pp. 449-70.

Moody’s Investors Services (2009), “Corporate Default and Recovery Rates, 1920-2008”, February.

Zhang J. and Zhu, F. and Lee, J. (2008), “Asset correlation, realized default correlation, and portfolio credit risk”, MKMV working paper. March 3.