For CECL and IFRS9 accounting, the choice of credit transition matrix and default probabilities is crucial and may have a significant impact on the final reserving required. The latest Credit Benchmark white paper demonstrates some of the key issues in choosing credit transition matrices:
- Market-implied PDs contain significant risk premiums, depending on credit category: these will tend to overstate impairments.
- Simple PD extrapolation may overstate or understate impairment, depending on credit category and the structure of the comparison matrix.
- Transition matrices derived from Rating Agency long run averages may understate impairment if the current PD volatility level is above the long run average; they will overstate impairment if the current PD volatility level is below the long run average.
- Crowd-sourced credit transition matrices based on broad, deep and frequently updated credit views address some of these shortcomings, providing:
- Real World PDs (undistorted by risk premium)
- Cumulative PDs which reflect the upgrades and downgrades embedded in the matrix (ignored by the so-called ‘survival’ approach)
- Frequently updated PD volatility and transition estimates from a very large underlying pool of 250,000 obligors
- Region and Sector specific PD volatilities and transition matrices
The paper is available to download here