Multi-State Markov Modelling of IFRS9 Default Probability Term Structure in Oracle-FSAA

Document Version: 0.3

Oracle-FSAA Target version: 8.0.4

Document Date: 23rd Jan 2016

© 2017 Oracle Corporation – Proprietary and Confidential Page 1

Abstract:
In June 2014, IASB, the International Accounting Standards Board had issued fresh guidelines on
provisioning for credit losses. These guidelines redefined the way institutions ascertained these
values. Historically, banks had arrived at Provisions for Credit Losses using the Incurred Loss
approach (as required by the erstwhile IAS 39 guidelines) but per IFRS 9, institutions are
required to compute the Expected Credit Losses by taking into account forward looking macro
economic factors. This significant shift will require institutions (banks) to rework on their
models to compute values such as Probability of Default (PD), Loss Given Default (LGD) and
Exposure at Default (EAD).

As per earlier requirements, banks computed risk values, namely Probability of Default on a
historical Through the Cycle basis for a twelve month time period. However, it is now required
to compute Point in Time values of PDs for both the Twelve Month duration and the Lifetime
duration (depending on the Significance of change in credit risk of an instrument since
inception) and these values (being PIT) are adjusted for forward looking macro-economic
expectations. The latter adjustment helps bank take into consideration any expected changes in
Economic cycle / business cycle.

One of the ways to arrive at the Point In Time PD is to make use of the Through the Cycle PD
which are computed for BASEL or regulatory purposes (which are Twelve month cycle neutral
values), project these over the life of the instruments and add macro-economic overlays over a
twelve month or Lifetime period.

Our offering:
We offer to implement a PD term structure model based on multi-state Markov (MSM)
Transformation. The inputs to the model are discrete grades that come from either bank’s
internal rating system or from the rating agencies, and macroeconomic cycle factors. The model
produces cumulative PDs over multiple tenor points, conditional on specific values of the
macroeconomic factors (macro scenarios).

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The overall context is shown in fig 1. Yearly Marginal probability
May be cycle independent Optional
or other wise

In the remaining part of this document

Transformation Macro-Economic
we describe at high level how the model Discrete grades
matrix Cycle factors
Merton R

is implemented in OFSAA LLFP. We

estimate and deploy the models with a
combination of using the Oracle R PD model

Enterprise (ORE) based models and other

OFSAAI platform components. IFRS9
Probability of
default (PD)

Fig: 1 Cumulative , Year on year,

cycle dependent PD

PD Modeling based on IFRS9 standards

The new ECL calculation rules which will come to effect from January 2018, can be described as
under,-.

Default Probability Calculation

In this section we briefly outline the main requirements for the estimation of default
probabilities from the IFRS9 Standard point of view.

Srl Criteria Comments

1 PD estimates should be unbiased ("best PD should accurately predict number of

estimate PD") defaults

Does not include optimism or

conservatism.

Appropriate adjustments need to be made

on regulatory capital models to remove
inherent conservatism.

2 Estimated PDs should be point-in-time Adjusted, where necessary, to reflect the

effects of the current economic conditions

3 Regular recalibration The PD estimates should be recalibrated

based on current representative sample
on a regular basis

Otherwise, monitoring should be provided

to show why recalibration was not

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 necessary

PD should be calculated using sufficient

sample size

Historical loss data should cover at least

one full credit cycle

4 The PDs should be calculated with PD model segments should consider

appropriate segmentation drivers in respect of borrower risk,
transaction risk and delinquency status
segment wise

Internal data used in building The PD

models, should be representative of the
portfolio segments.

5 Consistent Default Definition The data used for calibration should be

consistent with the IFRS 9 default
definition throughout

6 Avoid introduction of bias Techniques used to determine lifetime PD

measures should not introduce bias into
the calculation.

7 Consider macro-economic factors Future projected macroeconomic factors

should be used in the computation of
lifetime PD's.

8 Consistency Norms The risk of a default must be higher the

longer the expected life of the instrument
considering cumulative probability.

Tab: 1

The practical implications of these requirements is that PD term structure models need to be
quite sophisticated enough to project longer term in excess of 20 years. This is in contrast to
the one year time frame focus from The AIRB/Basel PD models. There are needs for flexibility
and recalibration as needed. Traceability is crucial as there is need to establish relevance of the
current model.

© 2017 Oracle Corporation – Proprietary and Confidential Page 4

Overall, the biggest challenge for PD modeling coming from IFRS9 is to link the defaults (or
more broadly rating migrations) to macroeconomic variables and to do so over a very long time
horizon.

Focus area IFRS9 AIRB/Basel

Term Long terms One year

PD model Cumulative Cycle dependent One year Cycle independent

Point in time One year time frame in focus

Accurate & Conditional on Conservative estimates

Macro-economic condition

Tab: 2

OFSAA LLFP Approach

Segmentation:

Segmentation of instruments into homogenous groups assists in performing various

computations (statistical or otherwise). It is required to create segments to enable the
generation of Historical transition matrix, generating PIT PDs, etc.

Historical Transition Matrix:

Historic data requirements are likely to have a significant impact on IFRS 9 requirements.

HTM is generated using long term averages and can be based on rating scales or DPD bands.
The last column of this matrix is the default probability also called the long term default
frequency.

This matrix can be used directly in the application or or adjusted for taking into account
changes in the credit processes (data representatives) - weighting or exclusions outside the
application

Generation of Point in Time PD term Structure:

From the average transition matrix, the transition / migration from a given Rating or
Delinquency band to the Default band represents Probability of Default for that Rating /
Delinquency band, for the corresponding time period. On projecting this transition matrix, Year

© 2017 Oracle Corporation – Proprietary and Confidential Page 5

on year, an asset may transition from one grade to another. The probability of transition to
default at the end of each year is the Through the Cycle (TTC) Probability of Default (cumulative
in nature).

When such Probability of default is adjusted for changes in macroeconomic variables, the
Probability of Default is Point in Time (PIT). Merton Model is used to convert PD-TTC to PD-PIT.

Per IFRS 9 guidelines, it is required to compute the probability weighted Expected Credit Loss
values. To enable this, multiple macro economic scenarios are defined with probability weights
to each of these scenarios.

The model, mentioned above, takes into consideration these probability weighted macro
economic scenarios to convert the TTC PDs to PIT PDs.

Overall approach is provided in Fig 1. Here we provide a more detailed flow,-

© 2017 Oracle Corporation – Proprietary and Confidential Page 6

1.Yearly Marginal probability
2.May be cycle independent or other wise
3.Portfolio wise data

Transformation
Discrete grades
matrix

Transformation process

Can Model other

methods
Year on year
Cumulative probability

Merton Model

Cumulative , Year on
Macro-Economic
year, cycle dependent Merton R
Cycle factors
PD

Smoothing

Smoothed Cumulative ,
Year on year, cycle
dependent PD

Fig: 2

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Example Data

Based on the historical data, a transition matrix is created which represents a probability of
shift from one grade to another at the end of each year. Transition matrix is thus a square
matrix. An example of transition matrix is given below –

Grades G1 G2 G3 D

G1 0.8 0.1 0.07 0.03

G2 0.05 0.7 0.15 0.1

G3 0.05 0.15 0.6 0.2

D 0 0 0 1

Tab: 3

Description:

In Tab: 3, the transition matrix effectively means that an asset in Grade G1 has 80% probability
of staying in G1 at the end of the year; 10% probability of moving to G2; 7% probability of
moving to G3 and 3% probability of defaulting.

The last column of a transition matrix is thus effectively the marginal PD-TTC for each grade.

Finding cumulative probability:

To make the demonstration clutter free, we further simplify the example with 2 non-default
grades and default. The calculation is represented as below,-

1 2 D

1 80% 15% 5%

2 70% 20% 10%

D 0% 0% 100%

Tab: 4
The above transition matrix (Tab: 4) represents
1. Probabilities of transitions from one grade to other.
2. This is one year probability

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 3. This probability scale is assumed to be constant for planning horizon(cycle independent,
but is not necessary for this to be so, bank may decide otherwise)
4. LLFP provides UI to define portfolio specific transition matrices year on year. These can
be either cycle dependent or otherwise.
5. LLFP provides crucial traceability to transition matrices from regulatory point of view.

So by definition, the state at 1st year end is as under

A=

1 2 D

1 80% 15% 5%

2 70% 20% 10%

D 0% 0% 100%

2nd year end by Markov transformation using Matrix multiplication

A*A=

1 2 D

1 80%*80%+15%*70+0%*5% … 80%*5%+15%*10%+5%*100%

2 … … …

D … … 100%

So on... for 3rd, 4th year etc, we can iteratively multiply.

It is worth noting that the probability of default is monotonically increasing year on year at
decreasing rate, which is the requirement for IFRS9.

Note:

80%*5%+15%*10%+5%*100% is cumulative probability of default of asset grade 1 in second

year and so on.

© 2017 Oracle Corporation – Proprietary and Confidential Page 9

So by iterative multiplication we arrive at year on year cumulative probability based on the
assumption of 1 year TTC PDs.

Now this is cumulative probability WITHOUT assuming cyclical fluctuations.

Adjusting Cyclical Fluctuations:

To convert PD-TTC to PD-PIT, we use the Merton Model, the formula is given below

PDPIT = Φ [Φ-1 (PDTTC ) + √R(CF’)/ √1-R)]

CF = Cyclical factors

R = Merton Coefficient, the value of which is between 0 and 1

Both of these are a download for the model

The basis for choosing macro-economic indicators and their forecasts is inevitably going to
diverge from bank to bank. There are several macroeconomic variables which impact the
probability of default. A combination of particular values of such variables is one scenario.

For each scenario, cyclical factors are computed using regression. Each scenario is given a
weight. For the model, cyclical factors are taken as download in the following form –

CF (Year/Scenario) Scenario 1 (75%) Scenario 2 (15%) Scenario 3 (10%)

2017 0.31733334 0.33733334 0.44733334

2018 0.30988819 0.46733334 0.57527355

2019 0.12125453 0.48333334 0.47666667

Tab: 5

Smoothing:

Once the TTC PDs are converted to PIT PDs for ‘N’ time periods in the future, it can be seen that the PIT
PDs drastically fall back to TTC PD values post those periods of macro-economic overlays. In order to
provide a slow fall back to TTC values, Smoothing (linear) is done to the resultant PD values.

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