A Forecast Model for the Probability of Default Based on Granular Firm-Level Data and Its Application to Stress Testing
May 31, 2019
Financial System and Bank Examination Department
Bank of Japan
Abstract
This Annex presents a model for forecasting the probability of default (PD) based on granular firm-level data. The model is intended for practical use by financial institutions, particularly for stress testing. The model comprises the following parts: (1) a main model that explains PD in terms of financial indicators of individual firms and (2) satellite models that specify relationships between macroeconomic indicators and financial indicators of individual firms. In the main model, the key financial indicator is the interest coverage ratio (ICR, an indicator of firms' debt repayment capacity), which is an efficient variable integrating firms' financial information on their solvency. The model is simple and tractable while also having high explanatory power with regard to actual firm defaults in the past. Therefore, the model is considered highly applicable to financial institutions' practices. This Annex applies the model to simple stress testing exercises based on two scenarios: a deterioration in the economy and a rise in interest rates.
In recent years, Japan's financial institutions have been actively lending to domestic middle-risk firms and overseas firms. Thus, it is becoming more important to accurately assess the stress resilience of financial institutions through detailed analyses of borrowing firms' creditworthiness and loan quality. The Bank of Japan's Financial System and Bank Examination Department has been collaborating with financial institutions in efforts to improve credit risk analysis and stress testing through increased use of granular data. This Annex is one of the outcomes. Using the analytical results in this Annex, the Bank of Japan will continue such efforts through a close exchange of views and information with financial institutions.
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Financial System and Bank Examination Department
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