The Vasicek credit framework is sometimes used to model PIT PD term structures. Institutions should be cognisant of the material challenges arising from using the Vasicek one-factor credit model (or similar derivations) for the purpose of ECL estimation, for the following reasons:
(i)
This model has been originally designed to model economic capital and extreme losses at portfolio level. It is designed to replicate the behaviour of credit risk for a granular and homogeneous portfolio. Whilst it is an elegant modelling construction, it might not be the most suitable approach to model expected loss behaviours at the level of individual obligors.
(ii)
It relies on parameters that are challenging to calibrate, in particular the asset correlation representing the correlation between (a) obligors’ asset value and (b) a non-observable systemic factor - generally assimilated to an industry factor for practical reasons. The model results are highly sensitive to the choice of this parameter. When modelling PIT PD, the introduction of this correlation parameter tends to reduce the impact of macroeconomic factors.
(iii)
When it is used for ECL, the Vasicek model is often combined with a macroeconomic regression model. In this case, the non-observable systemic factor is not a given input. Rather, it is partially driven by macro variables. Consequently, the commonly used one- factor model should be adjusted to account for the variance of the residuals, i.e. the part of the systemic factor that is not explained by the macro variables.
3.8.2
If an institution decides to use this methodology, this choice should be approved by the Model Oversight Committee, with a clearly documented rationale. The asset correlation parameters should be chosen carefully, bearing in mind the following principle: the lower the PD, the higher the asset correlation because the obligor’s performance is expected to be mostly driven by systemic factors rather than by idiosyncratic factors.
3.8.3
It is common practice to calibrate the asset correlation based on the values suggested by the Basel Framework employed for capital calculation. However, institutions should consider the possibility that the interconnectedness of corporates in the UAE could lead to higher systemic correlations for some industries. Consequently, institutions should, at a minimum, perform sensitivity analysis to assess the implications of this calibration uncertainty on PDs.