Forecasting Bank Loans Loss-given-default

by João A. Bastos of the Technical University of Lisbon

September 2009

Abstract: With the advent of the new Basel Capital Accord, banking organizations are invited to estimate credit risk capital requirements using an internal ratings based approach. In order to be compliant with this approach, institutions must estimate the expected loss-given-default, the fraction of the credit exposure that is lost if the borrower defaults. This study evaluates the ability of a parametric fractional response regression and a nonparametric regression tree model to forecast bank loan credit losses. The out-of-sample predictive ability of these models is evaluated at several recovery horizons after the default event. The out-of-time predictive ability is also estimated for a recovery horizon of one year. The performance of the models is benchmarked against recovery estimates given by historical averages. The results suggest that regression trees are an interesting alternative to parametric models in modeling and forecasting loss-given-default.

JEL Classification: G17, G21.

Keywords: Loss-given-default, Forecasting, Bank loans, Fractional response regression, Regression trees.

Published in: Journal of Banking & Finance, Vol. 34, No. 10, (October 2010), pp. 2510-2517.

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