Advanced Credit Model Performance Testing to Meet Basel Requirements: How Things Have Changed!

Donald R van Deventer, Li Li and Xiaoming Wang

INTRODUCTION

In Geneva in December 2002, Robert Merton was asked for his advice on the use by financial institutions of the credit risk model he created in 1974 to manage credit risk. After a long pause, Professor Merton replied, “Well, the first thing you have to remember is that the model is 28 years old.”¹¹Professor Merton’s comments were made at a major risk-management conference before an audience of approximately 400 risk-management experts. In the first edition of this Handbook, we puzzled over the persistence of the usage of Merton model by major financial institutions 30 years after its publication. The Merton technology’s obvious influence on the early versions of the then-proposed New Capital Accord (henceforth, Basel II) by the Basel Committee on Banking Supervision is a testimony to the powerful intuitive appeal of the model.

At the time, this was a concern to us because it seemed striking that the 1974 Merton technology, with modest extensions,²²An example is the extension of the Merton credit model to incorporate random interest rates by Shimko, Tejima and van Deventer (1993), who combined other Robert Merton insights from the 1970s with his credit model. Other