Structural Credit Modelling and Its Relationship to Market Value at Risk: An Australian Sectoral Perspective

Credit risk modelling has become increasingly important to Banks since the advent of Basel II which allows Banks with sophisticated modelling techniques to use internal models for the purpose of calculating capital requirements. A high level of credit risk is often the key reason behind banks failing or experiencing severe difficulty. The management of sectoral concentration is a critical component of credit risk management, as over concentration of credit in sectors can be a significant contributor to difficulties experienced by Banks. Conditional Value at Risk (CVaR) is gaining popularity as a measurement of credit risk, with the recognition that high lending losses are often impacted by a small number of extreme events. This study examines sectoral probability of default (PD) in an Australian context based on the structural approach of Merton (1974), and more recently modified and popularised by KMV Corporation (Crosbie & Bohn, 2003). In addition to examining PD, we introduce a CVaR type component into structural modelling which we term conditional probability of default (CPD). We also examine the interaction between sectoral credit and market risk using VaR and CVaR models for market risk, and PD and CPD models for credit risk. Significant rank correlation is found between all of the approaches used, showing that those sectors which are risky from a credit perspective are not significantly different from those which are risky from a market perspective.Value at risk, Conditional value at risk, Credit risk, Conditional probabilities of default, Structural modelling