Assessment of default probability in conditions of cyclicality Totmyanina Ksenia Moscow, 2014

Actuality Corporate sector represents a significant part of banking business worldwide. Loans to corporates are a significant part of Russian banking portfolio: to the end of 2013 loans to corporates reached 56% of total credit portfolio and 39% of total assets of Russian banks. Number of researches devoted to corporate credit risk estimation is strongly limited, especially for emerging market economies. Level of non-performing loans in corporate portfolio is increasing - this fact can lead to instability of Russian financial and banking system Construction companies are the most widespread among Russian borrowers and at the same time very exposed to systematic risks Object of research – Russian contracting companies Item of research – Assessment of default probability

Purpose of research The purpose of our research is to develop an empirical model for estimation default probability of potential corporate clients of Russian banks. The key steps to achieve this purpose are: research the different approaches to default definitions represent the classification of existing models to default modeling, review the advantages and disadvantages of these models analyze the nature and sources of the procyclicality effect, represent the review of available instruments to mitigation of the procyclicality effect collect the sample of financial indicators for defaulted and non-defaulted companies and macro factors for the specified period execute a statistical analysis to determine the sensetive financial indicators and macro factors execute a multivariable analysis to build sets of logit models analyze the quality and predictive power of final model and represent the economic interpretation of the observed relationship

Default definitions There are a lot of approaches: Default as non-fulfillment the conditions of the loan agreement due to inability or unwillingness of the borrower Default as the bankruptcy Default based on BIS criteria: overdue more than 90 days and / or bank considers that the debtor is unable to repay the loan

Review of default models 1.2 Market-based models 1.1 Fundamental-based models Rating-based models Cohort approach Macroeconomics models Binary choice models Univariate discrimination Multiple discrimination Reduced forms Structural models Models based on financial statements Scoring models Exogenous factors Endogenous factorsDuration approach 1.3 Advanced models Linear discrimination models Neuron networks Fuzzy sets models Probability of default models

Procyclicality issue Procyclical effect - increased business cycle fluctuations Sources can be different: 1) Prudential control: for example, capital adequacy requirements increase during periods of recession and reduce during the period of growth 2 ) The behavior of economic agents: for example, lending activity increase in periods of growth and decrease in periods of recession 3) Expectations of economic agents: for example, the risk is underestimated in the periods of growth, and overestimated during recessions 4) The corporate governance system: for example, the KPI systems and bonuses for managers

Mitigations of procyclicality

Financial parameters that can be statistically significant Group of financial factors potentially affecting the level of credit risk: Size Profitability Turnover Financial stability We formed a long list of financial indicators from each class above - finally total list consists of 31 indicators

Sample for modeling All defaulted companies in constructing industries during – 159 companies Default = bankruptcy For each defaulted companies we had 3 analogical (same size and industry) non-defaulted companies – 477 non-defaulted companies

Univariate analysis: selection of the risk dominant financial indicators Instruments: 1)Analysis and normalization of data (Chebyshev’s inequality) 2)Statistical tests to identify the most descriptive variables (Student's test, Welch tests, ANOVA test) More risk-dominant factors: Balance value Return on sales Working capital Share of stocks in current assets Return on assets Profitability of expenses Coefficient of autonomy

Univariate analysis: selection of the risk sensitive macro indicators Instruments: 1)Analysis and normalization of data (Chebyshev’s inequality) 2)Regression models between macro factors and average default rate (based on S&P data) More sensitive macro factors: Oil price Export of goods and services Imports of goods and services Current account Unemployment rate Loans to individuals

Multivariate analysis: a binary choice model Binary logit-models: where set of financial and macro factors if the company is default otherwise

Multivariate analysis On the basis of selected financial indicators and macro variables, all possible multivariate models were built The resulting combination was selected based on following criteria: No significant correlation Significance of indicators (t-statistic and F-test) The highest value Mc Fadden R2

Best model (Mc Fadden R2=32%): Stocks in current assets, profitability of expenses, coefficient of autonomy and import are most risk sensitive Share of stocks in current assets was included in the quadratic form that led to increase of R2 by 2% Multivariate analysis: results

Quality of model – classification table Model better predicts no default cases With the exclusion of macroeconomic indicators the quality of the model decreases

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