Fundamental design considerations for the long-term model
2009 EC INTERVIEWS
Different approaches are appropriate for different types of portfolios
Monte Carlo simulation vs. analytical solution:
The lack of flexibility of analytical approaches outweigh their efficiency and ease of implementation relative to simulation-based approaches*
Mark-to-model (MtM) vs. default mode
MtM is more accurate for long-term, low-PD facilities
A model with MtM capability can run in default mode, but the opposite is not true
MtM is the preferred approach in the industry, particularly for the corporate segment as it also tends to be conservative
Asset-return-based vs. default-intensity-based
Asset-return-based correlation is best suited for a corporate portfolio with readily available equity returns
Default-intensity-based correlation is most appropriate for SME and retail portfolios, which have a large number of observed defaults
Neither clearly emerges as a better structure for stress tests
MtM and default modes. Corporate banks prefer to run their models in MtM because it captures the inherent risk profile of high-tenure low-default-probability corporate portfolios. Banks focused on retail performance, by contrast, prefer to estimate the economic capital for their retail portfolio independent of the corporate portfolio and in default mode (see Exhibit 2 on the following page). DM is simpler to implement and sufficiently captures the high expected losses of the retail portfolio. Running the retail and corporate portfolios independent of each other does not, however, capture the benefits of diversification; banks are now researching ways to capture this benefit outside both the models.
The Basel II regulations require banks to calculate capital in default mode. Some of the banks we interviewed estimate only regulatory capital and use that to drive business decisions like pricing and performance management.
The ideal VaR model would be a simulation-based model in MtM mode. Corporate exposure correlation would proceed from an asset-based correlation model and retail exposure correlation from a default-intensity correlation. The correlation between corporate and retail could be based on the observed historical correlation of asset returns and default rates.