Credit Risk Models and the Basel Accords

The Bank for International Settlements is only 1-2 years away from effectively requiring all major financial institutions in the world to use a sophisticated credit models. The most widely used model is based on the 1974 Merton model of risky debt. A more recent extension of the Merton model of risky debt is the Shimko, Tejima and van Deventer (1993) model, which allows for simultaneous analysis of credit risk and interest rate risk.

Increasingly, however, bankers are turning to a newer class of models called "reduced form credit models" because of their analytical power for both complex derivatives like credit derivatives and the mark to market of loans on a credit adjusted basis.

The Basel Capital Accords place a heavy emphasis on financial institutions' ability to assess credit risk. In this book, two of the world's best-known risk management experts assess both the Merton model and reduced form credit models and show exactly how to measure model performance as the Basel Accords require. They use the same tests to assess the likely effectiveness of the Basel Capital Accords in measuring the safety and soundness of financial institutions.

The authors go into great detail in assessing the ability of leading credit models to evaluate collateralized debt obligations, loan commitments, collateralized loans, as well as retail and small business loan portfolios.

Credit Risk Models and the Basel Accords reviews the objectives of the credit risk management process, introduces the theory of the Merton and reduced form credit models, shows how the models can be used in practice, and then examines a wide range of historical data to show the relative performance of the models in practice.

This book offers a balanced review of the newer reduced form models and the older Merton model. It is an invaluable guide for financial institutions striving to meet the requirements of the new Basel Accord. It is a book that thoroughly reviews the pros and cons of both classes of credit model. The Basel Accords ensure that financial institutions do more than just "have" a model - they must also understand how they work. This book will help to fulfill that requirement of the new Basel Accords.

Donald R. Van Deventer founded the Kamakura Corporation in April 1990 and is currently President. He has been involved in financial advisory assignments involving both risk management and mergers and acquisitions, for the municipalities affected in the Orange County bankruptcy, in a major derivatives dispute between JPMorgan and a Korean securities firm, Bank Negara Malaysia, ITT Financial Corporation and many other leading institutions. Prior to founding Kamakura Corporation, he was Senior Vice President of in the investment banking department of Lehman Brothers (then Shearson Lehman Hutton). From 1982 to 1987, he was the treasurer for First Interstate Bancorp in LA, USA.

He holds a Ph.D. in Business Economics, a joint degree of the Harvard University Department of Economics and the Harvard Graduate School of Business Administration.

Kenji Imai heads Software Development for Kamakura and participates in selected Japan-related financial advisory assignments. A member of the Managing Committee of Kamakura, he is fluent in both Japanese and English.

Prior to Kamakura, Mr. Imai worked in credit analysis in the Foreign Exchange Group of the Sanwa Bank, Hibiya Branch. He was later transferred to the headquarters where as a member of the Planning Section, he was responsible for risk management on interest and currency products. Following his two years at MIT, he returned to the Derivatives Group at Sanwa where he developed interest rate term structure models for pricing exotic options and managing interest rate derivative products, and applied quantitative methods for swaps and options analysis.

He graduated from the University of Tokyo with a B.S. in Civil Engineering and from the Sloan School of the Massachusetts Institute of Technology with a M.S. in Management, concentrating in finance.