Credit risk rating models for FIs - use of structural models
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We have helped a client develop standard scorecard based credit risk rating models for financial institutions (counterparties are US/ international banks and broker-dealers)
The client is now getting questions from regulators why a structural model wasn’t considered (i.e. credit model with a forward-looking nature like for example KMV/ Moody’s EDF). We haven’t really seen structural models in this context outside of specific use cases (e.g., for structured credit, specialized lending like project finance, CRE, etc.)
Questions to the group:
- Has anybody seen structural models been applied to rate financial institutions?
- Are there any other (adjacent) use cases for structural models in rating financial obligors?
- Under what circumstances could a structural model risk rating model be advantageous?
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For some of FI segments, there just isn’t the coverage of quoted firms to allow use of structural credit models for all counter-parts – so if you want a consistently available rating, I’d assume classic scorecard approach will often provide better coverage (although may depend on your client’s portfolio – e.g. a couple of the UK banks have a roughly 50:50 split of rated vs not on their bank counterpart portfolio)
The other historical issue with structural models is that, without careful treatment, they can be too volatile for use in things like loan pricing (and also possibly for RWA estimation in the IRB framework) – but may be great as warning signals or in short-term deals.
Some of the UK banks have used structural model outputs as inputs to produce a point-in-time PD estimate, although my recollection is they tend to start with their internal more “through the cycle” rating as the starting point and then adjust based on structural models
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This may just be a rumour and so worth trying to Google to verify it, but I recall a long time ago that the MKMV model didn’t work well for banks, this was a known shortcoming of the model
It’s not at all clear what other type of structural model (other than something like KMV) one could even attempt for a bank…