Ebook Review of the literature on credit risk modeling: Development of the recent 10 years
In the August of 2007, the subprime lending crisis of United State has been shocking the world’s major financial markets. The fundamental reason for the crisis lies in the fact that asset price bubble which is brought about by excessive expansion of the real estate market has increased the risk preferences of investors. But it is also because the lending institutions driven by interest rates have loosened the credit risk management.
The usual risk taxonomy has three components: market risk, credit risk and operational risk. According to the New Basel Accords proposed (hereafter Basel II, see Basel Committee on Banking Supervision (2006)), market risk is the risk of loss in on and off-balance-sheet positions arising from movements in market prices. Credit risk is the risk of loss due to the probability an obligor (borrow, counter party) is unable or unwilling to pay its credit. And operational risk, which is broadly a residual category, is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Credit risk makes up about 50-60% of the total risk in a large bank (Kuritzkes et al. (2003)). Comparing with the situation that bulk of academic research focuses on market risk, credit risk has received less attention in the literature, until recently. In fact, we have seen an explosion of research over the last few years as the well-established tools and the measuring techniques find their way to the realm of credit assets assessment. Credit risk modeling attracts a diverse group of disciplines, from traditional finance (asset pricing) and mathematical statistics to econometrics. Because credit risk is the dominant risk for banks, regulators also pay particular attention to its measurement and management.
For the above mentioned facts it is time to summarize the literature on credit risk modeling, just as the overview given by Altman and Saunders (1998), which includes the developments on credit risk modeling over its past 20 years. However, no other review is done after it. In this paper, we try to trace the development from that time and summarize current knowledge on credit risk modeling. We cover more than 100 articles on credit risk which have appeared recently. Though these are not the full context on this topic, we believe that they include about 75% recent papers (It is argued later). Moreover, we use a criterion of article selection to select the articles of interested and they do represent, in our view, the best of the crop and illustrate the diverse set of issues and their treatments which have occupied the literature.
The paper is organized as follows. In Sections 2 and 3, we present the selection criterion and selection result for the articles we review in this paper. The main body of this review is from Section 4 to Section 9. We analyze the recent contributions in the credit risk modeling from several different aspects. Section 4 discusses the databases used in modeling loans’ credit risk. Section 5 examines the different definitions of general risk measures (default and losses given default) used by current articles. Section 6 presents the developments of credit risk modeling under different modeling frameworks. Section 7 mentions the popular commercial models. Section 8 summarizes the statistical tests, test strategies and other topics related to evaluating credit risk models. Section 9 covers the current increasing studies on modeling the credit risk of loan from small and median enterprise (SME). Section 10 is our main conclusions.
CONTENT
1. Introduction
2. Selection of articles
3. Articles to be reviewed
3.1 Selection result
3.2 Article classification
3.3 Development trend
4. Database used in model building and checking
5. Risk measures
5.1 Default
5.2 Losses given default
6. Credit risk models
6.1 BSM framework structural models
6.2 Individual-level reduced-form models
6.3 Portfolio reduced-form models
- 6.3.1 Poisson/Cox process model
6.3.2 Markov chain model
6.3.3 Factor model
6.3.4 Mortality analysis
7. Commercial models
8. Performance tests of credit risk
8.1 Statistical tests in credit risk modeling
8.2 Test Strategies
8.3 Evaluation of Bank’s Internal Rating
9. Studies on SME
10. Conclusion
GLOSSARY
REFERENCE
APPENDIX
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