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This paper benefits from comments by seminar participants at the IMF, Renzo Avesani, Antonio García-Pascual, Amadou Sy, and especially André Santos. Errors and omissions are the author’s sole responsibility.
Indeed, internal models for estimation of default probabilities are at the heart of Basel II, the revised framework for capital measurement and capital standards issued by the Basel Committee on Banking Supervision. This has prompted the rapid adoption of quantitative models of default probabilities among banks moving towards internal ratings-based (IRB) and Advanced-IRB approaches. Supervisors also need similar tools to be able to assess banks’ internal models.
For a comprehensive description and implementation of CreditRisk+ with a view towards stress testing, see Avesani, Liu, Mirenstean, and Salvati (2005).
Some recent examples of this approach include Alves (2005), Pesaran, Schuermann, Treutler, and Weiner, forthcoming, and Hoggarth, Sorensen, and Zicchino (2005) among others.
The description of these techniques are beyond the scope of this paper. A comprehensive explanation of these methodologies is Sobehart, Keenan, and Stein (2000).
See Basel Committee on Banking Supervision, Newsletter No. 6 (September 2005) “Validation of low-default portfolios in the Basel II framework.”