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Features of a Lifetime PD Model: Evidence from Public, Private, and Rated Firms

With the new CECL and IFRS 9 requirements, we see an increased need for lifetime probability of default models. In this document, we formally investigate and summarize the term structure properties consistently seen across public, private, and rated firms. We observe that the default rate for “good” firms tends to increase over time, while the default rate for “bad” firms decreases over time, an indication of the mean-reversion effect seen with firms' default risk.

May 2018 Pdf Sajjad Beygiharchegani, Uliana Makarov, Dr. Janet Zhao, Dr. Douglas Dwyer

A Composite Capital Measure Unifying Business Decision Rules in the Face of Regulatory Requirements Under New Accounting Standards

Prudent credit risk management ensures institutions maintain sufficient capital and limit the possibility of a capital breach. With CECL and IFRS 9, the resulting trend toward greater credit earnings volatility raises uncertainty in capital supply, ultimately causing an increase in required capital. It is ever more challenging for institutions to manage their top-of-the house capital while steering their business to achieve the desired performance level. This paper introduces an approach that quantifies the additional capital buffer an institution requires, beyond the required regulatory minimum, to limit the likelihood of a capital breach. In addition, we introduce a new measure that allocates capital and recognizes an instrument's regulatory capital requirements, loss allowance, economic concentration risks, and the instrument's contribution to the uncertainty in capital supply and demand. In-line with the Composite Capital Measure introduced in Levy and Xu (2017), this extended measure includes far-reaching implications for business decisions. Using a series of case studies, we demonstrate the limitations of alternative measures and how institutions can optimize performance by allocating capital and making business decisions according to the new measure.

May 2018 Pdf Dr. Amnon Levy, Xuan Liang, Dr. Pierre Xu

Default Risk Premium in the Equity Market

This paper explores the default risk premium within the equity market. To our knowledge, this is the first study that uses the commercially-available structural model, Moody's Analytics Public Firm Model, EDF9TM, to explain the cross-section of stock returns. While distressed stocks have attracted attention in the past for their anomalously low returns, we also identify outperformance of “safe” stocks. The notions of safe and distressed are both defined in the context of Distance-to-Default within the Moody's Analytics Public Firm Model(also known as KMV). Our findings revisit the notion that value, size, and momentum price the financial distress risk. We find that safe stocks outperform the market, and risky stocks significantly anomaly, our factor is not a proxy for the low volatility factor.

April 2018 Pdf Houman Dehghan, Pooya Nazeran

Measuring and Managing the Impact of IFRS 9 and CECL Requirements on Dynamics in Allowance, Earnings, and Bank Capital

Reserving for loan loss is one of the most important accounting aspects for banks. Its objective is to cover estimated losses on impaired financial instruments due to defaults and non-payment. Reserve measurement affects both the balance sheet and income statement. It impacts earnings, capital, dividends and bonuses, and attracts the attention of bank stakeholders ranging from the board of directors and regulators to equity investors. In response to the so-called “too-little, too-late” problem experienced with loan loss reserve during the Great Financial Crisis, accounting standard setters now require that banks provision against loan loss based on expected credit losses (ECL). Arguably, calculating the Expected Credit Loss Model under IFRS 9 and CECL presents a momentous accounting change for banks, with the new standards coming into effect sometime between 2018 and 2021, depending on the jurisdiction.

March 2018 Pdf Dr. Amnon Levy, Dr. Jing Zhang

Fitting Proxy Functions for Conditional Tail Expectation: Comparison of Methods

This paper details alternative methods for fitting proxy functions to CTE, employing quantile regression in combination with OLS among other techniques. We compare methods according to quality of fit for an example portfolio of variable annuities.

March 2018 Pdf Aubrey Clayton, Dr. Steven Morrison

Uncertainty in Asset Correlation Estimates and Its Impact on Credit Portfolio Risk Measures

Credit portfolio models rely on estimated and calibrated parameters, such as default and rating migration probabilities, recovery rates, and asset correlations. Users of these models must understand how various errors in the parameter estimates impact model outputs, for example Unexpected Loss (UL) or Economic Capital (EC). Asset correlations estimated using asset return time series are subject to inherent uncertainty — statistical errors — arising due to a limited length of the time series. The main question this paper addresses is how these errors translate into statistical errors in the estimated UL and EC. We illustrate several properties of the errors using an analytical method. As expected, longer time series lead to lower errors in UL and EC. Increasing the number of exposures in a portfolio, however, can reduce the errors in UL and EC only to a certain degree.

March 2018 Pdf Jimmy Huang, Libor Pospisil

Economic Capital Model Validation: A Comparative Study

Using a long history of public firm defaults from Moody's Investor Services and Moody's Analytics, this study illustrates a validation approach for jointly testing the impact of PD and correlation upon model performance. We construct predicted default distributions using a variety of PD and correlation inputs and examine how the predicted distribution compares with the realized distribution. The comparison is done by looking at the percentile of realized defaults with respect to the predicted default distribution. We compare the performance of two typical portfolio parameterizations: (1) a through-the-cycle style parameterization using agency ratings-based long-term average default rates and Basel II correlations; and (2) a point-in-time style parameterization using public EDF credit measure, and Moody's Analytics Global Correlation Model (GCorr™). Results demonstrate that a through-the-cycle style parameterization results in a less conservative view of economic capital and substantial serial correlation in capital estimates. Results also show that when point-in-time measures are used, the tested economic capital model produces consistent and conservative economic capital estimates over time. A version of this paper appears in the Journal of Risk Model Validation, March 2013.

February 2018 Pdf Zhenya Hu, Dr. Amnon Levy, Dr. Jing Zhang

November 2017 U.S. Middle Market Risk Report

Private firm default rates have declined steadily during the past five years. At 1.5%, the rolling 12-month default rate is down 73% from its September 2009 peak of 5.3%. This trend has been driven primarily by a decline in the charge-off rate, now at its lowest level in the past ten years. In addition, the rate of borrowers in non-accrual status has decreased 53% since September 2009. Banks downgraded 17% of borrowers on their internal rating scales during the past year, compared to 15% in 2016.

November 2017 Pdf Lin Moon, Stephanie Yu, Irina Korablev

Solvency In Sight - New Tools for Understanding the Impact of Investment Decisions on Capital

In this paper, we have considered the use of proxy models as a way of overcoming some of the operational and computational challenges associated with measuring future solvency under different market conditions and ALM assumptions.

October 2017 Pdf Dr. Steven Morrison

Toys R Us Exposure in CLOs

This report shows the CLO exposure to Toys R Us as of the latest available monthly surveillance report on September 8, 2017.

September 2017 Pdf Tess Likens

Combining Financial and Behavioral Information to Predict Defaults for Small and Medium-Sized Enterprises – A Dynamic Weighting Approach

One large challenge lenders currently face is how to combine different types of information into metrics that can support good business decisions. Currently, the banking industry uses two primary types of information — financial information and behavioral information — independently, to assess risk. Financial information includes Income Statement, Balance Sheet, Cash Flow, and Financial Ratios. Behavioral information includes spending and payment patterns, among others. Both types of information provide unique insights, but, to date, they have not been combined to generate one comprehensive risk metric for commercial use.

September 2017 Pdf Alessio Balduini, Dr. Douglas Dwyer, Dr. Janet Zhao, Sara Gianfreda, Reeta Hemminki, Lucia Yang

Moody's Analytics RiskCalc Transfer Pricing Solution

Tax authorities monitor cross-border, inter-company loan and financing transactions to curb tax avoidance and require arm's length pricing for such transactions. At the core of arm's length pricing is the process of understanding the creditworthiness of a borrower and identifying a typical interest rate charged to borrowers with comparable credit ratings. The Moody's Analytics RiskCalc Transfer Pricing Excel Template provides a consistent, analytical solution to the arm's length transfer pricing process. This document explains the methodology behind this tool.

August 2017 Pdf Dr. Janet Zhao, Jeunghyun Kim

Impact of Using EDF9 on Credit Portfolio Analysis

This paper investigates the impact of using EDF9 instead of EDF8 values as inputs for estimating credit portfolio risk measures within Moodys Analytics RiskFrontier®. The recent EDF9 enhancements affect portfolio risk analysis via various channels — due not only to new values for default probabilities, but also because the market Sharpe ratio (i.e. market-level risk premium) and asset return-based correlations for corporate exposures depend on time series of EDF measures. In this paper, we focus on the question of how using the new EDF9 default probabilities alter patterns in portfolio risk measures.

June 2017 Pdf Noelle Hong, Jimmy Huang, Libor Pospisil, Albert Lee, Marc Mitrovic, Sunny Kanugo, Tiago Pinheiro, Andriy Protsyk, Dr. Yashan Wang

A Composite Capital Allocation Measure Integrating Regulatory and Economic Capital, and the Impact of IFRS 9 and CECL

We propose a composite capital allocation measure integrating regulatory and economic capital. The approach builds upon the economic framework underpinning traditional RORAC-style business decision rules, allowing for an optimized risk-return tradeoff while adhering to regulatory capital constraints. The measure has a number of depictions, and it can be viewed as a weighted sum of economic and regulatory capital, as economic capital adjusted for a regulatory capital charge, or as regulatory capital adjusted for concentration risk and diversification benefits. Intuitively, when represented as economic capital adjusted for a regulatory capital charge, the adjustment can be represented as the additional top-of-the-house regulatory capital, above economic capital, allocated by each instrument's required regulatory capital. We show that the measure has ideal properties for an integrated capital measure. When regulatory capital is binding, composite capital aggregates to the institution's top-of-the-house target capitalization rate. We find the measure is higher than economic capital, but lower than regulatory capital for instruments with high credit quality, reflecting the high regulatory capital charge for this instrument class. Finally, we address how IFRS 9/CECL impacts the CCM and discuss the broader implications of the new accounting standards.

May 2017 Pdf Dr. Amnon Levy, Dr. Pierre Xu

CLO Rankings by Vintage (updated as of April 30, 2017)

In this report, Moody's Analytics has updated the prior deal rankings of the non-terminated 2006–2016 CLO's by vintage using a variety of scoring factors. CLO's that have had at least two payment periods are included.

May 2017 Pdf Peter Sallerson

May 2017 U.S. Middle Market Risk Report

Report highlights include: Private firm default rates have declined steadily during the past five years. At 1.5%, the rolling 12-month default rate is down 73% from its September 2009 peak of 5.3%. This trend has been driven primarily by a decline in the charge-off rate, now at its lowest level in the past ten years. Banks downgraded 16% of borrowers on their internal rating scales during the past year, compared to 14% in 2015. Among the ten states showcasing the largest change in EDF levels during the past ten years, Oklahoma and New Mexico experienced significant increases.

May 2017 Pdf Stephanie Yu, Irina Korablev, Stafford Perkins, Lin Moon

A Primer on Model Efficiency Techniques for Valuation of Large Life Insurance Portfolios

This paper provides an introduction to various techniques for efficient calculation of the market-consistent value of a portfolio of insurance policies. Two standard approaches to portfolio valuation are considered: (1) Use of different scenarios through different policies; (2) Portfolio compression through the use of model points. Additionally, the use of proxy functions is introduced as a novel approach to valuation of individual policies.

April 2017 Pdf Dr. Steven Morrison

FRTB Marginal Back-Allocation

This paper develops a method to back-allocate to individual positions the market risk capital requirement that a bank must satisfy under the revised standardized approach proposed by the Basel Committee. Our method assesses the contribution of single positions or sub-portfolios to the overall capital charge. One important feature of our method is that it provides insight on which positions, sub-portfolios, and risk factors drive the capital charge and which help mitigate it. A negative contribution indicates that a marginal increase in the position would lead to a decrease in the capital charge, and vice versa.

April 2017 Pdf Lorenzo Boldrini, Tiago Pinheiro

Estimating Commercial Real Estate (CRE) Stressed Loss Measures Under Federal Reserve 2017 Comprehensive Capital Analysis and Review (CCAR) Scenarios

For the 2017 CCAR program, the Federal Reserve published three macroeconomic and financial scenarios to be used in stress testing 34 CCAR financial institutions. In this study, we analyze 27 institutions, with a total of more than $760 billion in exposures to commercial real estate loans, using Moody's CMM Stress Testing framework. This report describes how we derive credit loss estimates for the CRE loan portfolios held by CCAR firms. This is our first study leveraging the loan-level commercial banks' data collected via Moody's Analytics CRE Credit Research Database (CRD™). Our analysis estimates that the expected nine-quarter, cumulative CRE portfolio loss through the first quarter of 2019 is 6.5% under the CCAR 2017 Severely Adverse Scenario. The primary factors behind the higher loss estimate compared to last year's stressed scenario (5.1% loss) is that this year's scenario features a slightly more severe economic downturn and a significantly larger decline in commercial real estate prices.

March 2017 Pdf Megha Watugala, Dr. Jun Chen, Wenjing Wang

What Do 20 Million C&I Loan Observations Say about New Origination Dynamics? — Insights from Moody's Analytics CRD Data

We construct and examine new origination of C&I loans to middle-market borrowers using the Loan Accounting System data extracted from Moody's Analytics Credit Research Database (CRD/LAS). We find that C&I loan origination declines during the Great Recession and recovers soon after. The magnitude of the decline and the speed of the recovery varies across segments. For example, new lending to the financial industry decreases more than to the non-financial industry during the recession and recovers faster afterwards. Another example, new originations during the recession consists predominantly of short-term loans, while long-term lending becomes more dominant post crisis. This finding suggests that banks are using loan tenor as a means to mitigate risk during crises, at times even more so than credit quality.

February 2017 Pdf Dr. Pierre Xu, Tomer Yahalom, May Jeng

Quantitative Research Webinar Series: Recovery Correlation Dynamics

The credit portfolio framework developed by Moody's Analytics accounts for links between default risk and recovery risk. We refer to these links as PD-LGD correlations.

February 2017 WebPage Noelle Hong, Yiting Xu

Measuring and Managing Credit Earnings Volatility of a Loan Portfolio Under IFRS 9

IFRS 9 materially changes how institutions set aside loss allowance. With allowances flowing into earnings, the new rules can have dramatic effects on earnings volatility. In this paper, we propose general methodologies to measure and manage credit earnings volatility of a loan portfolio under IFRS 9. We walk through IFRS 9 rules and the different mechanisms that it interacts with which flow into earnings dynamics. We demonstrate that earnings will be impacted significantly by credit migration under IFRS 9. In addition, the increased sensitivity to migration will be further compounded by the impact of correlation and concentration. We propose a modeling framework that measures portfolio credit earnings volatility and discuss several metrics that can be used to better manage earnings risk.

January 2017 Pdf Dr. Amnon Levy, Dr. Yanping Pan, Dr. Yashan Wang, Dr. Pierre Xu, Dr. Jing Zhang, Xuan Liang

Modeling Structured Instruments in RiskFrontier™ Software

Utilizing Moody's Analytics tranche simulations and their accurate measures of tranche risk, we have developed methodologies to represent structured instruments in the RiskFrontier software.

December 2016 WebPage Ian Ward, Tomer Yahalom

Quantitative Research Webinar Series: Modeling Through-the-Cycle Correlations

Many financial institutions prefer to take longer-term views when assessing the risks of their credit portfolio. While forward-looking or Point-in-Time (PIT) parameters might be more reflective of the current economic environment, frequent updates may create fluctuations in risk measures.

October 2016 WebPage Jimmy Huang

Using Loan Accounting System Data to Model New Origination

Modeling new origination is important for forecasting the future dynamics of a portfolio, and it is becoming prevalent for banks to use these models for capital and risk management, stress testing, and strategic planning. The main challenge is finding data on new origination dynamics over time.

October 2016 WebPage Tomer Yahalom

The Degree Regulatory Capital is Constraining and Impact on Investment Decision Rules

Pierre Xu, Associate Director of Portfolio Research at Moody's Analytics will discuss how required economic capital (EC) accounts for economic risks such as diversification and concentration effects.

October 2016 WebPage Dr. Pierre Xu

October 2016 U.S. Middle Market Risk Report

This semiannual report examines credit risk in the otherwise opaque U.S. private firm credit market. At 1.5%, the rolling 12-month default rate is down 73% from its September 2009 peak of 5.3%. This trend has been driven primarily by a decline in the charge-off rate, now at its lowest level in the past ten years. In addition, the rate of borrowers in non-accrual status has decreased 53% since September 2009. The number of borrowers rated “Substandard” has seen a steady increase since the first quarter of 2015, rising above pre-crisis levels, reflecting banks' cautious lending practices

October 2016 Pdf Irina Korablev, Stafford Perkins

Quantitative Research Webinar Series: The Degree Regulatory Capital is Constraining and Impact on Investment Decision Rules

Pierre Xu, Associate Director of Portfolio Research at Moody's Analytics will discuss how required economic capital (EC) accounts for economic risks such as diversification and concentration effects.

October 2016 WebPage Dr. Pierre Xu

Proxy Methods for Run-off CTE Capital Projection: A Life Insurance Case Study

In this paper, we show a practical application to forecasting capital requirements for real portfolios of participating whole life and annuity business, carried out in a joint research project between Moody's Analytics and New York Life Insurance Company.

October 2016 Pdf Dr. Steven Morrison, Aubrey Clayton

Quantitative Research Webinar Series: Multi-Period Credit Risk and Capital Planning with Proxy Functions

Financial institutions are seeking ways to gain a better understanding of their credit portfolios' risk dynamics, allowing them to foresee and to prepare for potential increases in capital requirements resulting from economic shocks.

October 2016 WebPage Aubrey Clayton, Xuan Liang
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