Ratings versus equity-based credit risk modelling: an empirical analysis

Working Paper no. 132
By Pamela Nickell, William Perraudin and Simone Varotto

Banks have recently developed new techniques for gauging the credit risk associated with portfolios of illiquid, defaultable instruments. These techniques could revolutionise banks’ management of credit risk and could in the longer term serve as a more risk-sensitive basis for calculating regulatory capital on banks’ loan books than the current 8% capital charge. In this paper we implement examples of the two main types of credit risk models developed so far, ratings-based and equity-based approaches. Using price data on large eurobond portfolios, we assess, on an out-of-sample basis, how well these models track the risks they claim to measure.

Ratings versus equity-based credit risk modelling: an empirical analysis