Capital allocation for credit portfolios under normal and stressed market conditions

TL;DR

This paper examines how different methods of estimating default probabilities and adjusting correlations influence capital allocation in credit portfolios under normal and stressed market conditions, aiming to improve active risk management.

Contribution

It analyzes the effects of point-in-time versus through-the-cycle PDs and correlation adjustments on capital calculations, proposing strategies for capital-levelling in dynamic markets.

Findings

Stressed market conditions have minimal impact when using TTC PDs.

PIT PDs require correlation adjustments to reflect stress.

Capital-levelling policies can be designed to adapt to market conditions.

Abstract

If the probability of default parameters (PDs) fed as input into a credit portfolio model are estimated as through-the-cycle (TTC) PDs stressed market conditions have little impact on the results of the capital calculations conducted with the model. At first glance, this is totally different if the PDs are estimated as point-in-time (PIT) PDs. However, it can be argued that the reflection of stressed market conditions in input PDs should correspond to the use of reduced correlation parameters or even the removal of correlations in the model. Additionally, the confidence levels applied for the capital calculations might be made reflective of the changing market conditions. We investigate the interplay of PIT PDs, correlations, and confidence levels in a credit portfolio model in more detail and analyse possible designs of capital-levelling policies. Our findings may of interest to banks that want to combine their approaches to capital measurement and allocation with active portfolio management that, by its nature, needs to be reflective of current market conditions.