Abstract

ABSTRACT

Portfolio Credit Risk Modelling for a Canadian SME Loans Portfolio

Jade Michel Haddad

The Basel II Capital Accords make strong and controversial assumptions on the behaviour of Small and Medium Enterprises (SMEs) in a credit portfolio. Benefiting from a rich, and as such rare, dataset of default and credit risk events, we measure the portfolio credit risk characteristics of one of the riskiest segments of the Canadian SME market. The depth of our data allows for robust segmentations of the data along dual dimensions, including risk grade and size of borrowers, not commonly found in the literature. This, in turn, allows for an SME-specific calibration of models for portfolio credit risk. In particular, we use the Merton-type asset value model (AVM) and the CreditRisk+ frameworks to present empirical estimates of the correlations that underline the relationship among borrower segments in the portfolio. In addition, we present loss distribution estimates for our SME portfolio under various extensions to the AVM and CreditRisk+. These extensions include a Multiple Correlated Sectors implementation of CreditRisk+ and simulation-based, as well as analytical implementations of both frameworks. Our results allow for a thorough testing of Basel II assumptions for portfolio credit risk and its application to SME borrowers. In particular, we present evidence in contrast to Basel II specifications on SME asset correlations, and quantify the impact of the single sector and infinite granularity assumptions in the Basel II Internal Ratings Based (IRB) approach to portfolio credit risk. Our work is undertaken within a consistent calibration of the AVM and CreditRisk+ frameworks and presents an SME-specific calibration refinement for CreditRisk+. Finally, we focus on capital allocations under the Basel II framework and present a partial implementation analysis quantifying the impact of the application of various Basel II conventions to our SME portfolio. Capital allocations from our internally-calibrated portfolio credit risk frameworks reveal a misallocation of capital among SME segments under Basel II. Given our thorough assessment of both Basel II and the credit risk characteristics underlying SME portfolios, we provide suggestions for an improved SME portfolio credit risk management framework.