Legacy Approaches to Credit Risk
In this chapter, we do for credit risk models what we did for interest rate risk models in Chapter 13. We go up into the risk management attic and dust off the tools that may have been best practice once, but which are only described that way now by a few. We review legacy credit ratings and the Merton model using the tools of Chapter 16. We do this because the selection of credit risk tools is not a beauty contest. It’s all about accuracy, period. Arguments to the contrary are usually about regulatory or corporate politics and the slow speed at which very large organizations respond to and absorb new technology. In that spirit, we explain why legacy credit ratings and the Merton default model, used almost exclusively for public firms, have been firmly outperformed by reduced form credit models. The dominance of the reduced form approach for retail borrowers and nonpublic firms has never been challenged by tools like legacy ratings and the Merton model, where the assumptions we outline below are even less appropriate than they are for public firms.
In this chapter, we return to using “Model Risk Alerts” with respect to statements known to cause problems or known to be false but commonly stated by practitioners.
THE RISE AND FALL OF LEGACY RATINGS
Almost every financial institution has used legacy credit ratings actively in both individual asset selection and in portfolio management at some point in its past. Ratings have a history measured ...