Annual Default Rates are Probably Less Than Long-Run Average Annual Default Rates

Abstract

Banks using either the Foundation or Advanced option of the internal ratings based approach to credit risk under Basel II capital requirements must estimate long-run annual average default probabilities for buckets of homogeneous assets. The one-factor model underlying the capital calculations in Basel II has implications for the distribution of average (across assets) default rates over time. One of these implications is that the average default rate in any period is probably smaller than the overall average default rate (over time and assets). The lesson for practitioners is that the short-term default experience of new, very safe assets is likely to underpredict the true long-run default rate for these assets.