Quantitative Financial Risk Management: Theory and Practice

CHAPTER 11

A Critique of Credit Risk Models with Evidence from Mid-Cap Firms

David E. Allen

Centre for Applied Financial Studies, University of South Australia and School of Mathematics and Statistics, University of Sydney

Robert J. Powell

School of Business, Edith Cowan University

Abhay K. Singh

School of Business, Edith Cowan University

INTRODUCTION

High bank failures and the significant credit problems faced by banks during the global financial crisis (GFC) are a stark reminder of the importance of accurately measuring and providing for a credit risk. There are a variety of available credit modeling techniques, leaving banks faced with the dilemma of deciding which model to choose. This article examines three widely used categories of models across a 10-year period spanning the global financial crisis (GFC) as well as pre-GFC and post-GFC in order to determine their relative advantages and disadvantages over different economic conditions. The comparison includes ratings-based models, accounting models, and structural models.

Ratings-based models incorporate external ratings models like Moody's, Standard & Poor's (S&P), or Fitch, and transition-based models such as CreditMetrics and CreditPortfolioView, which measure value at risk (VaR) based on the probability of loans within a portfolio transitioning from one ratings category to another. Accounting-based models provide a rating from the analysis of financial statements of individual borrowers, such as the Altman z-score and ...