A comparative analysis of current credit risk models

The new BIS 1998 capital requirements for market risks allows banks to use internal models to assess regulatory capital related to both general market risk and credit risk for their trading book. This paper reviews the curren t proposed industry sponsored Credit Value-at-Risk methodologies. First, th e credit migration approach, as proposed by JP Morgan with CreditMetrics, i s based on the probability of moving from one credit quality to another, in cluding default, within a given time horizon. Second, the option pricing, o r structural approach, as initiated by KMV and which is based on the asset value model originally proposed by Merton (Merton, R., 1974. Journal of Fin ance 28, 449-470). In this model the default process is endogenous, and rel ates to the capital structure of the firm. Default occurs when the value of the firm's assets falls below some critical level. Third, the actuarial ap proach as proposed by Credit Suisse Financial Products (CSFP) with CreditRi sk+ and which only focuses on default. Default for individual bonds or loan s is assumed to follow an exogenous Poisson process. Finally, McKinsey prop oses CreditPortfolioView which is a discrete time multi-period model where default probabilities are conditional on the macro-variables like unemploym ent, the level of interest rates, the growth rate in the economy, ... which to a large extent drive the credit cycle in the economy. (C) 2000 Elsevier Science B.V. All rights reserved. JEL classification: G21; G28; G13.