Internal risk models and the estimation of default probabilities

A major advancement in risk management among large financial institutions has been the development of internal risk models. The models encompass institutions' procedures and techniques for assessing portfolio risk. Commercial bank regulators in the U.S. and abroad have recognized that these "state of the art" risk-management tools provided a framework for addressing important shortfalls of current capital regulations. To that end, a key component of the new rules for bank capital regulation developed under the Basel II agreement allows for banks' internal risk-management systems to be part of the regulatory framework. This is known as the advanced approach and is intended for the largest and most sophisticated banking organizations. ; Key elements of internal risk models used under the advanced approach are the estimated probabilities of default (PDs) for bank assets. For example, a bank using the advanced approach would be required to deliver an estimate of the one-year PD for each corporate exposure. This Economic Letter describes some of the problems involved in estimating the required one-year PDs from banks' internal ratings data and details the approach taken in Christensen, Hansen, and Lando (2004) to address them.