Lifetime PD

From Open Risk Manual

Definition

Lifetime Probability of Default (PD) is the probability of a default event when assessed over the lifetime of a financial asset.

The lifetime PD is closely related with the Cumulative Default Probability, being the measurement (PD estimate) in the associated Credit Curve with a matching maturity (tenor).

The lifetime attribute emphasises a time horizon that is different from the shorter period (1-year period) that is used for regulatory reporting purposes under Basel II.

Estimation Methodologies

There is no single correct or appropriate method for estimating a lifetime PD measure as it applies to a very large variety of financial assets. The following dimensions are useful for classifying the possible options

  • Whether the method references an individual entity (corporate, sovereign) versus collective assessment for pools (retail, SME portfolios)
  • Whether the model estimation based on market data or historical default data
  • Different credit process assumptions based on (For a recent review in IFRS 9 context [1])
    • hazard rate models (also survival models)
    • markov chains (roll-rates or rating migration)
    • structural default models etc.

IFRS 9 Usage

The concept of lifetime PD is not formally defined in the Standard[2] but is implicit both in

  • the definition of Lifetime Expected Credit Losses as probability weighted amounts
  • the Significant Increase in Credit Risk indicator. With respect to SICR, when making the assessment, the reporting entity shall use the change in the risk of a default occurring over the expected life of the financial instrument instead of the change in the amount of expected credit losses.

Issues and Challenges

  • Credit Products with no defined maturity, e.g. Credit Cards
  • Low Default Portfolios
  • Increased Model Risk in particular over long time horizons

References

  1. Lifetime PD Analytics for Credit Portfolios: A Survey by V.Brunel
  2. IFRS Standard 9, Financial Instruments

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