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Concept
Probability of default
Summary
Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations.
PD is used in a variety of credit analyses and risk management frameworks. Under Basel II, it is a key parameter used in the calculation of economic capital or regulatory capital for a banking institution.
PD is closely linked to the expected loss, which is defined as the product of the PD, the loss given default (LGD) and the exposure at default (EAD).
The probability of default is an estimate of the likelihood that the default event will occur. It applies to a particular assessment horizon, usually one year.
Credit scores, such as FICO for consumers or bond ratings from S&P, Fitch or Moodys for corporations or governments, typically imply a certain probability of default.
For group of obligors sharing similar credit risk characteristics such as a RMBS or pool of loans, a PD may be derived for a group of assets that is representative of the typical (average) obligor of the group. In comparison, a PD for a bond or commercial loan, are typically determined for a single entity.
Under Basel II, a default event on a debt obligation is said to have occurred if
it is unlikely that the obligor will be able to repay its debt to the bank without giving up any pledged collateral
the obligor is more than 90 days past due on a material credit obligation
The PD of an obligor not only depends on the risk characteristics of that particular obligor but also the economic environment and the degree to which it affects the obligor. Thus, the information available to estimate PD can be divided into two broad categories -
Macroeconomic information like house price indices, unemployment, GDP growth rates, etc. - this information remains the same for multiple obligors.
Obligor specific information like revenue growth (wholesale), number of times delinquent in the past six months (retail), etc.
Official source
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Bond credit rating
In investment, the bond credit rating represents the credit worthiness of corporate or government bonds. It is not the same as an individual's credit score. The ratings are published by credit rating agencies and used by investment professionals to assess the likelihood the debt will be repaid. Credit rating is a highly concentrated industry with the "Big Three" credit rating agencies – Fitch Ratings, Moody's and Standard & Poor's (S&P) – controlling approximately 95% of the ratings business.
Credit risk
Credit risk is the possibility of losing a lender holds due to a risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs.
Credit rating agency
A credit rating agency (CRA, also called a ratings service) is a company that assigns credit ratings, which rate a debtor's ability to pay back debt by making timely principal and interest payments and the likelihood of default. An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments, and in some cases, of the servicers of the underlying debt, but not of individual consumers. Other forms of a rating agency include environmental, social and corporate governance (ESG) rating agencies and the Chinese Social Credit System.