IRJMST Vol 12 Issue 5 [Year 2021] ISSN 2250 – 1959 (0nline) 2348 – 9367 (Print)

The Various Stages In Modelling Credit Risk under CREDITRISK+ : A

Deep Dive

Dr. A.R.Sainath1, Viji T.V.2

Authors: Dr. A.R. Sainath, Professor, Department of Management Studies, New Horizon College of Engineering,
Bangalore, Karnataka, India. Email: arsainath01@gmail.com , Mobile No: 9986559798
Ms. Viji T.V., Ph.D Research Scholar, Department of Management Studies, New Horizon College of Engineering,
Bangalore, Karnataka,India. Email: viji.asish@gmail.com, Mobile No: 9742363004

ABSTRACT
The analysis of uncertainty is the core of any risk management approach.Therefore the computation
of variability of loss and the probability of possible levels of unexpected loss is vital to essential
management of credit risk. The CreditRisk+ is an important and widely implemented default model
of credit risk which is based on a methodology borrowed from actuarial mathematics.It has been
developed by Credit Suisse Financial Products (1996) and is typically used in modelling the
distribution of losses in the field of banking and insurance. The approach applies mathematical
techniques to model sudden events of obligor default.The focus is majorly on the default and does
not consider migration of credit ratings,ie, the model does not examine changes in the economic
value of the exposure due to downgrades or upgrades of credit quality.Hence only default risk is
modelled, not downgrade risk and the model makes no assumption on the causes of default.This
approach is typically used in losses originating in insurance portfolios.Default rates of the
borrowers are considered as continuous random variables and the volatility of default rates are
incorporated in order to capture the uncertainty in the level of default rates.This allows for an
explicit calculation of a full loss distribution for a portfolio of credit risk exposures.This loss
distribution is quantified by combining the effects of two components - Frequency of Defaults and
Severity Of Losses This paper focuses on the various stages in modelling credit risk under the
Creditrisk+ Modelling Framework.
Keywords : actuarial mathematics, Frequency of defaults, Severity of losses, Distribution of
default losses.
CreditRisk+ Model, introduced by the Credit Suisse Financial Products (CSFP),uses a
portfolio approach and analytical methods which are popularly used in the insurance industry and
can be applied on loans, bonds,financial letters of credit and derivatives of lenders, particularly
banks.It comprises of a methodology for calculating the economic capital for credit risk.This method
takes into account the information relating to the size and maturity of the exposure as well as the
credit quality and the systematic risk of the borrower. The methodology also includes setting aside
provisions on an anticipatory basis.
LITERATURE SURVEY
Abdelkhader Derbali (2018) investigates the different characteristics of credit risk models and tries
to calculate the default probability of a credit portfolio using CreditRisk+ model and also discusses
the forces and weaknesses of the model.Renzo G Avesani, Kexue Liu, Alin Mirestean and Jean
Salvati (2006) presents the CreditRisk+ model along with extensions which helps determine the
probability distribution of loans in a portfolio of loans and other debt instruments.This model

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assumes the default probabilities as a linear multifactor model and the analytical approximation of
the model may be imprecise if the probabilities of default are too high.Diana Diaz and Gordon
Gemmill (2015) compares the CreditRisk+ model with another portfolio Approach model called the
CreditMetrics and concludes that although both models are able to capture the information about
defaults at very high confidence levels, for low quality portfolios, the CreditRisk+ estimates upto
16% higher than the CreditMetrics.For high quality portfolios also, the CreditRisk+ estimates higher
CVARs than CreditMetrics, except for high confidence levels.Hermann Haaf and Dirk Tasche
(2002) tries to model an alternative approach to compute Var from the loss distribution.Gotz Giese
(2003) discusses the CreditRisk+ methodology from the perspective of moment generating function
of the credit factors.The representation lends itself to a new recursion formula for the portfolio of
loss distribution that is more accurate and considerably faster, particularly for large portfolios.Alex
Derviz, Narcisa Kudlackova (2001) reviews the ‘The New Basel Capital Accord’ and the underlying
concepts, institutional preconditions of the implementation of CreditRisk+ and its data requirements
along with three other models within the Banking Sector of Czech Republic.
OBJECTIVES OF THE STUDY
The CreditRisk+ model ,a well established credit risk management technique ,reflects a
modern approach to modelling the credit risk of lending portfolios by making use of the two key
attributes:Default rate and Default Rate Volatility, along with background factors that may cause the
incidence of default events to be correlated. The Credit Risk is modelled in two stages -
1.Estimating the frequency of defaults and estimating the severity of losses in the first stage and
2.Calculation of the distribution of default losses in the second stage which involves a discussion of
two separate cases.
The paper discusses briefly these two stages that are essential to quantify risk measures such as
Expected Shortfall, and Value at Risk.
BASIC MODEL SETTING
CreditRisk+ belongs to a group of statistical techniques to model the sudden event of obligor
default.In the event of default ,the model makes no assumptions regarding the causes of default and it
is assumed that each borrower or counterparty can assume only one of the two states at the end of the
constant risk horizon of one year - default (0) with a probability P or non default (1) with a
probability 1-P. It is assumed that the PD during a one year (risk horizon) is the same as the PD for
any other year.Also, given a large number of borrowers or counterparties, the PD of any one
borrower is small and the number of defaults that occur during any 1 year is independent of the
number of defaults occurring during any other year.
Suppose that a financial institution has n loans of a given type.For the sake of simplicity, it
is assumed that these loans are homogenous in terms of risk so and the one year probability of
default of each loan is represented as p, which can be obtained from external and internal credit
ratings, depending on preference.In other words, it is assumed that all the loans belong to the same
rating class.Let 𝜇 be the expected number of defaults for the whole portfolio of loans,𝜇 = np.If we
assume that the defaults are independent, then the probability of observing m defaults over a total of
n loans is very similar to tossing a coin( assume biased) n times and observing m heads, where the
probability of getting a head is p.If it is assumed that p, the probability of default of each
counterparty is very small and n the number of counterparties is large, then the probability

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distribution of a number of defaults is well approximated by the Poisson

Distribution.Then,probability of m defaults=𝑒 −𝜇 𝜇 𝑚 /𝑚!

Possible Frequency
of default Excluding Default
default rate
rate rate Volatility
path
outcomes
Including
Default rate
Volatility

Fig1. graphs showing the defaultrate distribution with and without incorporating volatility,
Note : adapted from CreditSuisseFirstBoston(1997)- CreditRisk+,A Credit Risk Management Framework

The default rate is treated as a continuous variable and the possible default rate over a given time
horizon is described by a distribution which is specified by a default rate and volatility of default rate
similar to how a forward stock price and a stock price volatility are used to define a forward stock
price distribution.The probability of observing m defaults can then be combined with the historical
information about the probability distribution of the losses experienced when a certain type of
counterparty defaults.This leads to the computation of a probability distribution for the total losses
from the defaults.On that distribution , quantities like Value At Risk (Var) and Expected Shortfall
(ES) can be computed and from those quantities ,we can further obtain the capital requirements
according to the AIRB Methodology.
Model Inputs and Outputs
The inputs include credit exposures ( Book value), expected default rates assigned to each borrower
based on market credit spreads or credit ratings, borrower default rate volatilities, the recovery rates
that reflect seniority of obligation and collateral and the Risk sectors.Default correlations are not
used as direct input due to the fact that they are inherently unstable.Moreover there is a lack of
empirical data on default correlations.The output of the model calculates a full loss distribution for a
portfolio of credit exposures.

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STAGES IN MODELLING CREDIT

1)Default rates, 1)Exposures
Inputs
2)Volatilities of default rate 2)Recovery rate

Frequency of Defaults Severity Of losses

Stage 1

Stage 2 Distribution of default losses

RISK
Fig 2. Basic block Diagram of the stages involved in modelling Credit Risk under the CreditRisk + Framework.
note:adapted from CreditSuisseFirstBoston(1997) -CreditRisk+,A Credit Risk Management Framework

STAGE 1:
Estimation of Frequency of Defaults: this refers to the estimation of the number of defaults in a
portfolio over a risk horizon. The two inputs being - the average default rates and the volatility of
defaults.
Estimation of the Severity of losses : In the case of default of an obligor, the counterparty incurs a
loss equal to the amount possessed by the obligor less a quantity of restoring.The exposure of every
obligor is adjusted by the rate planned by restoring or recovery rate , to calculate the loss given
default (LGD ).
STAGE 2:
Calculation of the default losses distribution for a Portfolio :The model calculates the loss
distribution under two separate cases as illustrated in the diagram below.

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CALCULATION OF THE DEFAULT Default rate Sector Analysis

LOSS DISTRIBUTIONS OF A uncertainty
PORTFOLIO

Default events with fixed Default events with variable

default rates default rates
Convergence of variable
default case to fixed default
Default losses with fixed Default losses with variable
default rates default rates

Calculation of loss Calculation for loss distribution

distribution with fixed default with variable default rates.
rates

Application to multi year General Sector Risk Contributions

losses Analysis and Pairwise
correlations

CASE 1 CASE
2

Fig 3. Calculation of loss distribution under two cases

Note : adapted from CreditSuisseFirstBoston(1997) -CreditRisk+,A Credit Risk Management Framework
CASE 1:
(1)Default events with fixed default rates
Credit defaults occur as a sequence of events in such a way that it is not possible to forecast the exact
time of occurrence of any one default or the exact total number of defaults. The probability of
realising n default events in the portfolio in 1 year is given by P{X= n defaults} = (e -μμn )/ n!The
probability generating function gives information of the occurrence of default events within the
portfolio.The distribution does not depend on the number of exposures in the portfolio or the
individual probabilities of default but only on the expected number of defaults(μ).
(2)Default losses with fixed default rates
After obtaining the distribution of the number of defaults, the next objective is to understand the
probability of suffering given levels of loss from the portfolio which is elaborated in the following
steps.
Step i: Slotting exposures into bands
The first step in obtaining the distribution of losses from a portfolio is to group the similar sized
exposures in the portfolio into bands.Banding introduces an approximation into the calculation by
reducing the amount of data that is incorporated into computation.This corresponds to the fact that
precise amounts of exposures are not critical in determining the overall risk.

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If there are A number of borrowers , the PD associated with each borrower be P A ,L is a unit amount
of exposure in the base currency and LA be the exposure, then the exposure of each borrower( v A )
is given by vA = LA / L. Similarly let λA (λA = PA * LA ) be the expected loss and therefore the
expected loss for each borrower εA is given by εA = λA/ L. Let the portfolio be divided into ‘m’
exposure bands indexed by j (1 ≤ 𝑗 ≤ 𝑚) and therefore each band is characterized by
εj = μj * vj and therefore μj = εj / vj. Here, μj indicates the expected number of defaults in the portfolio
in one year which is a known value and vj indicates the exposure expressed in a multiple of L in the
known band j and εj the expected loss for the band j.
Step ii :Calculating the expected number of defaults in each band
If the expected number of default events in each expected band is μj , then the total number of
expected default events in a portfolio in one year (μ) is
𝑗 𝑗
μ = ∑𝑖=1 μj = ∑𝑖=1 εj / vj
where εj =ΣεA, and μj = εj / vj = Σ εA, / vA
Step iii: Calculation of the Probability Generating Function for each band and for entire
portfolio
To derive the distribution of losses, a probability generating function for losses is defined which is
expressed as multiples of units of the exposure. G(z) = ∑∞𝑛=0 P(aggregate losses = n* L)zn
As each band or a portfolio of exposures is independent from other bands and the probability
generating function of the entire portfolio is the product of the Probability Generating Functions of
each band as given by
G(z) = ∏𝑚𝑗=1 Gj(Z) = ∏𝑚 𝑗=1 exp(- ∑𝑚𝑛=0 μj +∑𝑚
𝑗=1 μj zvj)
G(z) = F( P(z)) where P(z) ={ ∑𝑚 𝑗=1 μj zvj }/μ where μj = εj / vj
This functional form for G(z) depends on only v and ε and therefore to obtain the distribution of
losses for a large portfolio, what is needed is the knowledge of the different sizes of exposures v
within the portfolio together with the share of expected loss arising from exposure size ε. This is
typically a very small amount of data even for a large portfolio.

Step iv: Calculate the Loss distribution for the entire portfolio
The following formula is arrived at where An is the probability of loss of ‘n’ units of a portfolio.
An = ∑𝑗: 𝑣𝑗 ≤ 𝑛 (εj /n ) * A n-vj
(3)Application to multiyear losses
This loss distribution that has been calculated for a 1 year horizon can be extended to multi year
periods by building a term structure of default for the portfolio.To achieve this marginal rates of
default must be specified for each future year in the portfolio, for each borrower. Collectively, such
marginal default rates specify the term structure of default of the portfolio.The formula of
distribution of losses of one year distributed to a multiyear time horizon 0 to T, indexed by t is given
by An = ∑𝑗: 𝑣𝑗 ≤ 𝑛 (ε(t)j /n ) * A n-vj(t)
CASE 2:
(1)Default Events with Variable Default Rates
This scenario assumes variable default rates.It can be stated that the observed default probabilities
are volatile over time even for obligors with a sound credit quality.This variability in default rates is
assumed to result from ‘background factors’ like state of the economy which could influence the
earnings of the borrowers and therefore the portfolio of borrowers. The measurement of background
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factors is addressed by dividing the borrowers into different sectors.Therefore the inputs to the model
are default rates with uncertainty and sector analysis.
(2)Sector analysis
The concept of sector analysis is necessary in order to measure and quantify the effect of the
uncertainty that arises from factors that may affect a large number of borrowers within a
portfolio.The factors could be many and each factor likely to have a uniform influence on the
obligors within a country, but little influence on other obligors in a multinational portfolio.The
background factors are measured by dividing the obligors among the different sectors where each
sector is a collection of obligors under the common influence of a major factor or a few factors that
affect default rates.The sectors are assumed to be independent. The mean related to expected loss
within a sector Sk = 1≤ 𝑘 ≤ 𝑛 is given by
𝑚(𝑘)
μk = ∑𝑖=1 εj(k) / vj (k) .
For each sector, in addition to the expected rate of default μk , a standard deviation σk has to be
specified.μk can be expanded as a sum over all obligors as μk = ∑𝐴 εA/ vA = ∑𝐴 pA where pA
expresses the probability of default of the obligor A over the time period and σ A is the standard
deviation assigned to the obligor A.the standard deviation of defaults within a sector is given by
σk = ( ∑ 𝐴 σA ) / (∑𝐴 pA ) * μk
(3)Default losses with variable default rates
The probability generating function for default events in one sector is the average of the conditional
probability generating function over all possible values of the default rate as the following
computation shows
∞ ∞
Fk(z) = ∑∞𝑛=0 P( n defaults) zn = ∑∞
𝑛=0 zn ∫𝑥=0 P( n defaults| x)f(x)dx = ∫𝑥=0 e x(z-1) f(x)dx
Where xk represents the average default rate in sector k.To get the appropriate formula for
probability generating function, an appropriate distribution for x k is chosen This is the gamma
distributionて( 𝛼,β ).The ‘Gamma Distribution’ is a skewed distribution that approximates to the
Normal Distribution where the mean is large.This continuous probability distribution has two
parameters - a scale and a shape parameter- called 𝛼 and 𝛽.It is fully described by the mean μ and the
standard deviation σ such that μ = 𝛼 𝛽 and σ = 𝛼 𝛽 2. Hence for every sector ‘k’, the parameters of
the related Gamma distribution is given by 𝛼k = μ2k / σ2k and 𝛽k = σ2k / μk.In this scenario, the
portfolio is divided into n sectors with annual mean default rates following a gamma distribution
defined by 𝛼 and 𝛽 given above. With the choice of the gamma distribution, The probability
generating function is given by
∞
Fk (z) = ∫𝑥=0 e x(z-1) f(x)dx
The probability generating function for each sector k is given by the equation
Fk(z) = { (1-pk)/(1-pkz) } 𝛼k , where pk = 𝛽k/ ( 1+𝛽k )
This can be summed up to obtain the Probability Generating Function for n sectors.
(4)Calculation of loss distribution with variable default rates
The probability generating function for the distribution of loss amounts of the portfolio is given by
G(z) = ∑∞𝑛=0 P(aggregate losses = n* L)zn and G(Z) = ∏𝑚 𝑗=1 Gj(Z)
𝑚(𝑘)
A polynomial p(z) is defined such that pk(z) = 1/ μk ∑𝑗=1 {(εj(k) / vj (k) ) * zv j (k) )}
so that Gk(z) = Fk( Pk(z))
The closed form of the probability generating function is given by

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𝑚(𝑘)
G(z) = ∏𝑛𝑘=1 Gk (z) = ∏𝑛𝑘=1 { (1-pk) / [ 1 - (pk/ μk) * ( ∑𝑗=1 (εj(k) / vj (k) ) * zv j (k) )] 𝛼k}
Further a loss distribution is calculated for the above probability generating function.
(5)Convergence of Variable Default Rate to Fixed Default Rate Case
Although the credit risk model is designed to incorporate the effects of variability in the average
rates of default, there are two circumstance when the model behaves as if the the default rates are
fixed.These are when the standard deviation of the mean default rate for each sector tends to zero and
when the number of sectors tend to infinity.
(6)General Sector Analysis
The probability generating function for the distribution of losses assumed that the portfolio is divided
into sectors each of which is a subset of the total set of obligors.This corresponds to a situation in
which obligors fall into classes each of which is driven by one factor but all of which are mutually
independent.In a more general circumstance, it is not possible to describe the portfolio with sectors
consisting of groupings of obligors.Therefore, the concept of sector is replaced with that of
systematic factor.The probability generating function was derived by expressing it as a product over
the sectors and then integrating with respect to the distribution of default rates of each sector.
∞
G(z) = ∏𝑛𝑘 = 1 Gk(z) = ∏𝑛𝑘 = 1 ∫𝑥=0 exp( xk(Pk(z)-1) fk(xk)dxk
This expression can be viewed as a multiple integral
∞ ∞
G(z) = ∫𝑥1=0 ….∫𝑥𝑛 =0 exp ( ∑𝑛𝑘=1 xk(Pk(z) - 1) ) fk(xk)dxk
The exponent in the integrant exp ( ∑𝑛𝑘=1 xk(Pk(z) - 1) ) = ∑𝑛𝑘=1 ∑𝐴⋲𝑘 ( xkεA / μk vA )(z vA-1)
is described using a delta function as given by δAk = { 0 , if A∉k and 1 if A⋲k}
The function becomes ∑𝐴⋲𝑘 δAk (xkεA / μk vA) (z vA-1). The delta function is replaced by θAk or
the allocation of the obligors among the sectors by choosing for each obligor A such that θ Ak
:∑𝑛𝑘=1 θAk = 1
The allocation represents the extent to which the default probability of obligor A is affected by the
factor underlying the sector k.
exp ( xk(Pk(z) - 1) ) = ∑𝑛𝑘=1 ∑𝐴⋲𝑘 ( xkεA / μk vA )(z vA-1) = ∑𝐴⋲𝑘 θAk (xkεA / μk vA)(z vA-1).
where Pk(z) = 1/ μk∑𝐴 θAk (εA / vA) (z vA-1).

(7)Performing Sector Decomposition and Incorporating Specific Factors

It is assumed that for each obligor in the portfolio estimate has been made of the extent to which the
volatility of the obligor’s default rate is explained by the factor k.The number θ Ak represents our
judgement of the extent to which the state of sector K influences the fortunes of obligor A.The mean
for each sector is the sum of contributions from each obligor weighted by the allocations of θAk .
Thus μk = ∑𝐴 θAk μA.
It has been assumed that all variability in the default rates in the portfolio is systematic.But there is a
requirement of an additional sector to model factors specific to each obligor.Hence for a portfolio
comprising of a large number of obligors, the sector that incorporates specific factors would be
assigned a total standard deviation given by
σk = ∑ 𝐴 θAk σA.

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The specific factor sector then behaves as the limit of a large number of sectors, one for each
borrower in the portfolio with independent variability of the default rate.
(8)Risk Contributions and Pairwise Correlations
1. Risk contributions are defined as the contributions made by each borrower to the unexpected
loss of the portfolio, measured by a percentile level or standard deviation.It is shown that the
risk contributions add up to the standard deviation of the portfolio of the loss distribution.
2. Pairwise correlation between default events give a measure of the extent to which the
concentration risk is present in the portfolio.The formula for pairwise correlation is
ρAB = ( μAμB)½ ∑𝑛𝑘=1 θAθB ( σk / μk )2
The equation states that if the borrowers A and B have no sector in common , then the correlation
between them is 0.This is because systematic factors affect them both.Also, it states that the default
correlations are of the same order of the default probabilities themselves.
FINDINGS
1. In the credit environment, empirical data is very difficult to obtain.The CreditRisk+ model
focuses only on default, thus requiring only a very few input parameters to estimate and
hence minimize the risk of errors due to uncertainty of the parameters.
2. The low data requirements and minimum assumptions makes the model easy to implement
for a wide range of portfolios, thus making the model expandable and adaptable.
3. The distribution of default events is compounded with the information of the distribution of
exposures to obtain the loss distribution of the portfolio.
4. The extent of diversification of the portfolio is observable from the calculated loss
distributions.
5. The effect of concentration risk within the portfolio is captured using sectoral analysis
6. The model actually used by banks is more complex from a mathematical point of view with
more realistic components.
7. The model does not work for non-linear portfolios where exposures vary in a non linear way
with the market.
8. The model is amenable to extensions that incorporate the effects of ratings changes and the
effects correlated credit events
CONCLUSION
Credit Suisse Financial Products’ CreditRisk+ Model has been freely released to the public in 1997,
and has been considered a benchmark in managing the credit risk of Indian banks as per the
Guidance Note on Credit Risk Management issued by the RBI. The basic problems in the Indian
Banking Sector include limitations on the banks’ internal default data as well as devising a
satisfactory way in modelling the covariation in credit risk across different exposures.The
estimation of some parameters such as assigning of obligors to sectors may require judgment and is
a challenge.As discussed, the measurement and management of portfolio risk is based on the two
key attributes of correlation and volatility.The CreditRisk+ Model is one such analytic -based
portfolio model that helps estimate the loss distribution associated with a portfolio as well as
identify the risky components by inspecting the risk contribution of each member in the portfolio. It
proposes a macro economic factor model for analysing credit portfolio correlation - this approach
involves projecting the performance of a credit portfolio under altering macroeconomic
environments which involves a stress test on the debt servicing ability of portfolio of borrowers

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