Lifetime PD
Contents
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 (formula) 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 and estimation methods:
- 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 Credit 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
