Determining the Probability of Default and Risk-Rating Class for Loans in the Seventh Farm Credit District Portfolio

Abstract

Credit risk is the primary risk facing financial institutions. With the proposed guidelines under the New Basel Accord, financial institutions will benefit from better assessing their risks. The probability of default (PD) and risk-rating class is studied 157,853 loans in the Seventh Farm Credit District Portfolio. Repayment capacity, owner equity, and working capital origination loans are important determinants of the PD. Standard & Poor's (S&P) reported probabilities of default were used to classify each of the loans into a risk-rating class. The average predicted PD is 1.61%, which would fall into the BB- S&P class. Capital management is a significant topic financial institutions as they prepare to meet new guidelines under the proposed New Basel Accord (Basel Committee on Banking Supervision). The advanced options of the Accord will require financial institutions to assess their credit, market, and operational risk, to link these risks to capital management, and to comply with safety and soundness regulations for uniform application throughout the institution (Barry 2001). The goals of the Accord are to tailor risk measurement and capital management to the characteristics of diverse financial institutions and to more finely distinguish segments of their loan portfolios. Credit risk is the primary source of risk to financial institutions. As part of the credit risk assessment, the Accord suggests more granularity in risk-rating classes than currently exists, along with other improvements to existing riskrating systems. Many banks are using more advanced rating systems under the N Allen M. Featherstone is a professor of Agricultural Economics at Kansas State