The Probability of Default is the likelihood that a loan will not be repayed and fall into default. PD is calculated for each client who has a loan (for wholesale banking) or for a portfolio of clients with similar attributes (for retail banking). The credit history of the counterparty / portfolio and nature of the investment are taken into account to calculate the PD. There are many alternatives for estimating the probability of default. Default probabilities may be estimated from a historical data base of actual defaults using modern tecniques like logistic regression. Default probabilities may also be estimated from the observable prices of credit default swaps, bonds, and options on common stock. The simplist approach, taken by many banks, is to use external ratings agencies such as Egan Jones, Fitch, Moody's Investors Service, or Standard and Poors for estimating PDs from historical default experience. For small business default probability estimation, logistic regression is again the most common technique for estimating the drivers of default for a small business based on a historical data base of defaults. These models are both developed internally and supplied by third parties. A similar approach is taken to retail default, using the term "credit score" as a euphemism for the default probability which is the true focus of the lender.
How to calculate the Probability of Default???
The following steps are commonly used
Analyse the credit risk aspects of the counterparty / portfolio;
Map the counterparty to an internal risk grade which has an associated PD: and
Determine the facility specific PD. This last step will gives a weighted Probability of Default for facilities that are subject to a guarantee or protected by a credit derivative. The weighting takes account of the PD of the guarantor or seller of the credit derivative.
