Credit risk – Probabilities of default models

Sergio Scandizzo and Tony Hughes

INTRODUCTION

Although climate risk can impact every financial activity and thus potentially affect all risk categories, credit risk is by far the primary concern, certainly because it represents the largest exposure for most financial institutions, but also because it is straightforward to adapt the existing supervisory framework, routinely used for the analysis of stress scenarios.

The development of models for the assessment of credit risk has evolved in response to several macroeconomic factors as well as to radical shocks of both a financial and regulatory nature. In the years following the end of the Bretton-Woods agreement, the main determinants of this evolution were the increase in volatility and consequent number of bankruptcies as well as the technological advancements behind progressive disintermediation and the rise of off-balance sheet derivative instruments. More recently, impulse for ever more refined credit risk analysis has come from competition in margins and yields, driven by low interest rates and globalisation as well as, unsurprisingly, from the fallout and industry-wide soul-searching that followed the 2008–2009 financial crisis (Hao, Alam and Carling, 2010)