Empirical estimation of default and asset correlation of large corporates and banks in India

Purpose – Estimation of default and asset correlation is crucial for banks to manage and measure portfolio credit risk. The purpose of this paper is to find empirical relationship between the default and asset correlation with default probability, to understand the effect of systematic risk. Design/methodology/approach – The authors have estimated single default and implicit asset correlations for banks and corporates in India and compare it with global scenario. This paper deduces a simple methodology to estimate the default correlations from the variance of temporal default rates. Next, the asset correlations have been estimated analytically by decomposition of variance equation in Merton's one factor risk model following approaches of Gordy and of Bluhm and Overbeck. Findings – The authors empirically find a negative relationship between asset correlation and the probability of default using Moody's global corporate data that support Basel II internal ratings-based (IRB) correlation prescription. However, they do not find any smooth relationship between the probability of default (PD) and asset correlation for Indian corporate. The magnitude of correlation estimates based on a large bank's internal rating-wise default rates are much lower than what is prescribed by the Basel committee. Thus, the standardized correlation figures as assumed by the Basel Committee on Banking Supervision need to be properly calibrated by the local regulators before prescribing their banks to calculate IRB risk weighted assets. Originality/value – These correlation estimates will help the regulators, insurance firms and banks to understand the linkage between counterparty default risks with the systematic factors. The findings of this paper could be used further in estimating portfolio economic capital for large corporate exposures of banks and insurance companies. JEL classification: G21, G32, C15