Estimating Probability of Default for the Foundation IRB Approach in Countries that had Experienced Extreme Credit Crises

Abstract

A bank employing the Foundation IRB approach of Basel II may face digression of the regulatory capital from the economic capital, when PDs are estimated improperly. Nevertheless, validation of estimated PDs is not an easy task due to lack of reliable default data. For a bank operating in a country that had experienced extreme credit crises, however, estimating PDs based upon the assumptions that the default probability distribution is skewed and that observed default rates during the crises correspond to a very high confidence level might provide adequate protection against unexpected capital shortage. We show simulation results that highlight the benefit of this approach.