Migration in structural credit rating models

Abstract

Banks that choose credit rating models for capital calculations depending solely on an accuracy criterion may overlook the effect of their selection on the rating migration that could lead to higher capital requirements. Although most of the recognised factors affecting migration such as macroeconomic conditions, country and sector are not related to the bank, the model's selection is an internal decision that could reduce capital charges. In this paper, we focus on assessing the migration differences of two popular structural credit risk models in corporate lending, the Merton's distance to default and the econometric model using the logit function. The key conclusion of this paper is that migration between the two models can be substantially different depending on the parameters' values. This result highlights banks' need to consider migration levels together with prediction accuracy when selecting a credit rating model for their regulatory and economic capital calculations.