An Extended Analytical Approach to Credit Risk Management

Among the ‘reduced form models’ for measuring the credit risk of a bank’s portfolio is CreditRisk+, which provides a closed-form solution for calculating the portfolio loss distribution based on an actuarial approach. The limitations of this model are well known, but they are often misinterpreted as being deeply embedded within the model. Dismantling the mathematical components of the model allows one to modify and extend it in several ways while remaining within an analytical approach. One of the most unattractive features is the orthogonality of the background factors or sectors as it hinders any resemblance to real-world macroeconomic indexes or industrial sectors and geographical areas. Among other extensions, which we mention briefly, we present in more detail how the original model can be amended to consider correlations among default risk sectors and among severity risk segments. These extensions are applied to reallife data, based on mortality rate data produced by the Italian Central Bank. (J.E.L.: C00, C51).