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The Analytics of Risk Model Validation
 Quantitative Finance Series

Aims and Objectives

• books based on the work of financial market practitioners, and academics
• presenting cutting edge research to the professional/practitioner market
• combining intellectual rigour and practical application
• covering the interaction between mathematical theory and financial practice
• to improve portfolio performance, risk management and trading book performance
• covering quantitative techniques
Market
Brokers/Traders; Actuaries; Consultants; Asset Managers; Fund Managers; Regulators; Central
Bankers; Treasury Officials; Technical Analysts; and Academics for Masters in Finance and MBA
market.
Series Titles
Return Distributions in Finance
Derivative Instruments: Theory, Valuation, Analysis
Managing Downside Risk in Financial Markets
Economics for Financial Markets
Performance Measurement in Finance
Real R&D Options
Advanced Trading Rules, Second Edition
Advances in Portfolio Construction and Implementation
Computational Finance
Linear Factor Models in Finance
Initial Public Offerings
Funds of Hedge Funds
Venture Capital in Europe
Forecasting Volatility in the Financial Markets, Third Edition
International Mergers and Acquisitions Activity Since 1990
Corporate Governance and Regulatory Impact on Mergers and Acquisitions
Forecasting Expected Returns in the Financial Markets
The Analytics of Risk Model Validation

Series Editor
Dr Stephen Satchell
Dr Satchell is a Reader in Financial Econometrics at Trinity College, Cambridge; visiting Professor
at Birkbeck College, City University Business School and University of Technology, Sydney. He
also works in a consultative capacity to many firms, and edits the Journal of Derivatives and Hedge
Funds, The Journal of Financial Forecasting, Journal of Risk Model Validation and the Journal of
Asset Management.
The Analytics of Risk Model
Validation
Edited by

George Christodoulakis
Manchester Business School, University of Manchester, UK

Stephen Satchell
Trinity College, Cambridge, UK

AMSTERDAM • BOSTON • HEIDELBERG • LONDON • NEW YORK • OXFORD

PARIS • SAN DIEGO • SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO

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First edition 2008

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No part of this publication may be reproduced, stored in a retrieval system

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or property as a matter of products liability, negligence or otherwise, or from any use
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herein.

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Contents

About the editors vii

About the contributors ix
Preface xiii

1 Determinants of small business default 1

Sumit Agarwal, Souphala Chomsisengphet and Chunlin Liu
2 Validation of stress testing models 13
Joseph L. Breeden
3 The validity of credit risk model validation methods 27
George Christodoulakis and Stephen Satchell
4 A moments-based procedure for evaluating risk forecasting models 45
Kevin Dowd
5 Measuring concentration risk in credit portfolios 59
Klaus Duellmann
6 A simple method for regulators to cross-check operational risk loss
models for banks 79
Wayne Holland and ManMohan S. Sodhi
7 Of the credibility of mapping and benchmarking credit risk estimates for
internal rating systems 91
Vichett Oung
8 Analytic models of the ROC curve: Applications to credit rating
model validation 113
Stephen Satchell and Wei Xia
9 The validation of the equity portfolio risk models 135
Stephen Satchell
10 Dynamic risk analysis and risk model evaluation 149
Günter Schwarz and Christoph Kessler
11 Validation of internal rating systems and PD estimates 169
Dirk Tasche

Index 197
This page intentionally left blank
About the editors

Dr George Christodoulakis is an expert in quantitative finance, focusing on financial

theory and the econometrics of credit and market risk. His research work has been
published in international refereed journals such as Econometric Reviews, the European
Journal of Operational Research and the Annals of Finance and he is a frequent speaker
at international conferences. Dr Christodoulakis has been a member of the faculty at Cass
Business School City University and the University of Exeter, an Advisor to the Bank of
Greece and is now appointed at Manchester Business School, University of Manchester.
He holds two masters degrees and a doctorate from the University of London.

Dr Stephen Satchell is a Fellow of Trinity College, Reader in Financial Econometrics at

the University of Cambridge and Visiting Professor at Birkbeck College, City University of
Technology, at Sydney, Australia. He provides consultancy for a range of city institutions
in the broad area of quantitative finance. He has published papers in many journals and
has a particular interest for risk.
This page intentionally left blank
About the contributors

Sumit Agarwal is a financial economist in the research department at the Federal Reserve
Bank of Chicago. His research interests include issues relating to household finance, as
well as corporate finance, financial institutions and capital markets. His research has been
published in such academic journals as the Journal of Money, Credit and Banking, Journal
of Financial Intermediation, Journal of Housing Economics and Real Estate Economics.
He has also edited a book titled Household Credit Usage: Personal Debt and Mortgages
(with Ambrose, B.).
Prior to joining the Chicago Fed in July 2006, Agarwal was Senior Vice President
and Credit Risk Management Executive in the Small Business Risk Solutions Group of
Bank of America. He also served as an Adjunct Professor in the finance department
at the George Washington University. Agarwal received a PhD from the University of
Wisconsin-Milwaukee.

Joseph L. Breeden earned a PhD in physics in 1991 from the University of Illinois. His
thesis work involved real-world applications of chaos theory and genetic algorithms. In
the mid-1990s, he was a member of the Santa Fe Institute.
Dr Breeden has spent the past 12 years designing and deploying forecasting systems for
retail loan portfolios. At Strategic Analytics, which he co-founded in 1999, Dr Breeden
leads the design of advanced analytic solutions including the invention of Dual-time
Dynamics. Dr Breeden has worked on portfolio forecasting, stress testing, economic
capital and optimization in the US, Europe, South America and Southeast Asia both,
during normal conditions and economic crises.

Souphala Chomsisengphet is Senior Financial Economist in the Risk Analysis Division

at the Office of the Comptroller of the Currency (OCC), where she is responsible for
evaluating national chartered banks’ development and validation of credit risk models for
underwriting, pricing, risk management and capital allocation. In addition, she conducts
empirical research on consumer behavioral finance, financial institutions and risk manage-
ment. Her recent publications include articles in the Journal of Urban Economics, Journal
of Housing Economics, Journal of Financial Intermediation, Real Estate Economics, and
Journal of Credit Risk.
Prior to joining the OCC, Chomsisengphet was an economist in the Office of Policy
Analysis and Research at the Office of Federal Housing Enterprise Oversight (OFHEO).
She earned a PhD in Economics from the University of Wisconsin-Milwaukee.

Kevin Dowd is currently Professor of Financial Risk Management at Nottingham Univer-

sity Business School, where he works in the Centre for Risk and Insurance Studies. His
research interests are in financial, macro and monetary economics, political economy,
x About the contributors

financial risk management and, most recently, insurance and pensions. His most recent
book Measuring Market Risk (second edition) was published by John Wiley in 2005.

Klaus Duellmann is Director in the research section of the Department of Banking and
Financial Supervision in the central office of the Deutsche Bundesbank in Frankfurt.
There, he performs research in economic capital models, in particular for credit risk,
market risk and the interaction of risks. He has been a member of various working groups
of the Basel Committee on Banking Supervision. He is Associate Editor of the Journal of
Risk Model Validation. He holds a PhD from the faculty of business administration at
the University of Mannheim, graduated in mathematics from the Technical University of
Darmstadt and in business administration from the University in Hagen.

Wayne Holland is Senior Lecturer in the Operations group at Cass Business School,
City University London, and Deputy Director for the upcoming Centre of Operational
Excellence, London. He has a PhD in queueing analysis from Cardiff. His areas of interest
lie in bootstrap simulation methods, risk analysis, and simulation modelling applied to
operational risk and supply-chain risk.

Christoph Kessler is Executive Director and works in the Risk Management team at UBS
Global Asset Management. His work concentrates on the analytics used in the bank’s
proprietary risk management system and the estimation process for the risk models. He
joined the former Swiss Bank Corporation in 1988 as Risk Manager in the newly emerging
Derivatives markets and later moved into the asset management area. His academic career
includes a Diploma from the University of Freiburg, a PhD from the University of Bochum
in Mathematics and post-doc work at the University of Hull, with majors in Mathematical
Logic and in Stochastic Processes.

Chunlin Liu is Assistant Professor of Finance with College of Business Administra-

tion, University of Nevada. He teaches courses in bank management, investment and
international finance. His current research interests include banking, consumer finance
and capital markets. He has published in the Journal of Money, Credit, and Bank-
ing, Journal of Financial Intermediation, Journal of International Money and Finance,
Journal of International Financial Markets, Institutions & Money, International Review
of Economics & Finance, Southern Economic Journal, Quarterly Review of Economics
and Finance, Journal of Economics and Finance and the Asia-Pacific Financial Markets.
Prior to his career in academia, he worked in the banking industry as a financial economist.
Chunlin Liu received his PhD in Finance from University of Rhode Island. He is also a
CFA charterholder.

Vichett Oung is a postgraduate in Finance, Econometrics and Statistics. He graduated

from the ENSIIE, French Engineering School of Information Technology, and received
his Master of Science from Aston University, as well as two Masters of Arts in both
Finance and Statistics from CNAM University. He started his career in 1995 as a Financial
Economist at the Commission Bancaire, the French Banking Supervisor, where he mana-
ged the banking research unit and was much involved at the international level within
the context of the Basel II project, as a member of the Research Task Force of the Basel
Committee. He developed a specific interest and expertise in credit risk model validation.
About the contributors xi

After the completion of Basel II, he has moved in 2004 to the field of monetary and
financial economics upon joining the Banque de France as Deputy Head of the Monetary
Analysis and Statistics Division.

Günter Schwarz is Managing Director and the Global Head of the Risk Management team
at UBS Global Asset Management, where he is in charge of coordinating risk management
research and support, and in particular the proprietary risk management systems and
models of UBS Global Asset Management. He began his career in 1990 at the then Swiss
Bank Corporation, working in the area of asset management and risk analysis most of
the time. His academic background is a Diploma and a PhD in Mathematics from the
University of Freiburg, specializing in Stochastic Processes and Mathematical Statistics.

ManMohan S. Sodhi is Head of the Operations group at Cass Business School, City
University London. He is also Director of the upcoming Centre of Operational Excellence,
London that includes operational risk among its research themes. He has a PhD in
Management Science from University of California, Los Angeles and after teaching at
the University of Michigan Business School for two years, he worked for a decade in
industry with consultancies including Accenture before coming to Cass in 2002. His
current research interests are in risk management processes and modelling associated with
operations.

Dirk Tasche joined Fitch Ratings as Senior Director in the Quantitative Financial Research
(QFR) group. Dirk is based in London and will focus on group’s efforts regarding
credit portfolio risk and risk scoring models. Prior to joining Fitch, Dirk was a risk
analyst in the banking and financial supervision department of Deutsche Bundesbank,
Frankfurt am Main. He was mainly involved in the European Union-wide and national
German legal implementation of the Basel II Internal Ratings Based Approach (IRBA).
Additionally, he was charged with research on economic capital models and their imple-
mentation in financial institutions. Prior to Deutsche Bundesbank, Dirk worked in the
credit risk management of HVB, Munich, and as a researcher at universities in Germany
and Switzerland. He has published a number of papers on measurement of financial risk
and capital allocation.

Wei Xia is Executive Consultant in the Risk and Capital group, PricewaterhouseCoopers
LLP UK, responsible for cross-asset class derivative valuations and quantitative market
risk and credit risk consulting. Wei is also a PhD candidate in Quantitative Finance at
Birkbeck College, University of London and visiting lecturer at University of International
Business and Economics, Beijing, China. He was a quantitative developer at Winton Cap-
ital Management responsible for designing and developing an in-house risk measurement
and reporting system.
This page intentionally left blank
Preface

The immediate reason for the creation of this book has been the advent of Basel II.
This has forced many institutions with loan portfolios into building risk models, and,
as a consequence, a need has arisen to have these models validated both internally and
externally. What is surprising is that there is very little written that could guide consultants
in carrying out these validations. This book aims to fill that gap.
In creating the book, we have become aware that many of these validation issues have
been around for a long time and that the need for this book probably predates Basel
II. Of particular interest for investment banks and asset management companies are the
problems associated with the quantitative risk management of ones own money and client
money.
Clients in particular can become litigious, and one of the key questions that arise is
whether the risk of the client portfolio has been properly measured. To assess whether this
is so requires the validation of the portfolio risk model. This area is virtually non-existent
but has some features in common with Basel I. Thus, it is considered good practice to
consider back-testing, scenario analysis and the like. Purveyors of risk models claim to
test their products themselves, but they rarely make their models available for external
validation. This means that the asset manager needs to take responsibility for the exercise.
As editors, we were delighted that a number of young and prominent researchers in the
field were happy to contribute to this volume. Likewise, we thank the publishers for their
understanding, Anne Mason who managed the document harmoniously and the Bank
of Greece whose support for risk management helped bring about the creation of this
project.
This page intentionally left blank
1 Determinants of small business default ∗

Sumit Agarwal† , Souphala Chomsisengphet‡ and Chunlin Liu¶

Abstract
In this paper, we empirically validate the importance of owner and business credit risk
characteristics in determining default behaviour of more than 31 000 small business loans
by type and size. Our results indicate that both owner- and firm-specific characteristics
are important predictors of overall small business default. However, owner characteristics
are more important determinants of small business loans but not small business lines. We
also differentiate between small and large business accounts. The results suggest that owner
scores are better predictors of small firm default behaviours, whereas firm scores are better
predictors of large firm default behaviour.

1. Introduction
In this chapter, we develop a small business default model to empirically validate the
importance of owner and the business credit bureau scores while controlling for time to
default, loan contract structure as well as macroeconomic and industry risk characteristics.
In addition, several unique features associated with the dataset enable us to validate the
importance of the owner and business credit bureau scores in predicting the small business
default behaviour of (i) spot market loans versus credit lines and (ii) small businesses
below $100 000 versus between $100 000 and $250 000.
Financial institutions regularly validate credit bureau scores for several reasons. First,
bureau scores are generally built on static data, i.e. they do not account for the time
to delinquency or default.1 Second, bureau scores are built on national populations.
However, in many instances, the target populations for the bureau scores are region-
specific. This can cause deviation in the expected and actual performance of the scores.
For example, customers of a certain region might be more sensitive to business cycles and
so the scores in that region might behave quite differently during a recession. Third, the

∗
The authors thank Jim Papadonis for his support of this research project. We also thank seminar participants
at the Office of the Comptroller of the Currency, Office of Federal Housing Enterprise Oversight, Brent
Ambrose, Michael Carhill, John Driscoll, Ronel Elul, Tom Lutton, Larry Mielnicki, and Nick Souleles for
helpful discussion and comments. We are grateful to Diana Andrade, Ron Kwolek, and Tim Murphy for
their excellent research assistance. The views expressed in this research are those of the authors and do not
represent the policies or positions of the Office of the Comptroller of the Currency, of any offices, agencies,
or instrumentalities of the United States Government, or of the Federal Reserve Bank of Chicago.
†
Federal Reserve Bank of Chicago, Chicago, IL
‡
Office of the Comptroller of the Currency, Washington, DC
¶
College of Business Administration, University of Nevada, Reno, NV
2 The Analytics of Risk Model Validation

bureau scores may not differentiate between loan type (spot loans versus lines of credit)
and loan size (below $100K and above $100K), i.e. they are designed as one-size-fits-all.
However, it is well documented that there are significant differences between bank
spot loans (loans) and lines of credit (lines). For example, Strahan (1999) notes that firms
utilize lines of credit to meet short-term liquidity needs, whereas spot loans primarily
finance long-term investments. Agarwal et al. (2006) find that default performance of
home equity loans and lines differ significantly. Hence, we assess whether there are any
differences in the performance of small business loans and lines, and if so, what factors
drive these differences?
Similarly, Berger et al. (2005) argue that credit availability, price and risk for small
businesses with loan amounts below and above $100K differ in many respects. Specifically,
they suggest that scored lending for loans under $100K will increase credit availability,
pricing and loan risk; they attribute this to the rise in lending to ‘marginal borrowers’.
However, scored lending for loans between $100K and $250K will not substantially
affect credit availability, lower pricing and lesser loan risk. This is attributed to the price
reduction for the ‘non-marginal borrowers’. Their results suggest that size does affect
loan default risk.
Overall, our results indicate that a business owner’s checking account balances,
collateral type and credit scores are key determinants of small business default. However,
there are significant differences in economic contributions of these risk factors on default
by credit type (loans versus lines) and size (under $100K versus $100K–250K). We find
that the effect of owner collateral is three times as much on default for small business
loans than for lines. This result is consistent with Berger and Udell’s (1995) argument that
a line of credit (as opposed to loan) measures the strength of bank–borrower relationship,
and as the bank–firm relationship matures, the role of collateral in small business lending
becomes less important. Our results also show that the marginal impact of a 12-month
increase in the age of the business on lowering the risk of a small business defaulting is
10.5% for lines of credit, but only 5.8% for loans. Moreover, a $1000 increase in the
6-month average checking account balance lowers the risk of default by 18.1% for lines
of credit, but only 11.8% for loans. Finally, although both owner and firm credit scores
significantly predict the risk of default, the marginal impacts on the types of credits differ
considerably. The marginal impact of a 10-point improvement in the owner credit score
on lowering the risk of defaults is 10.1% for lines, but only 6.3% for loans. A similar
10-point improvement in the firm credit score lowers the risk of default by 6.3% for
small business loans, but only 5.2% for small business lines. These results are consistent
with that of Agarwal et al. (2006).
Comparing small businesses under $100K (small) and those between $100K and $250K
(large), we find that the marginal impact of a 10-point improvement in the owner credit
score in lowering the risk of default is 13.6% for small firms, but only 8.1% for large
firms. On the contrary, the marginal impact of a 10-point improvement in the firm credit
score in lowering the risk of default is only 2.2% for small firms, but 6.1% for the
larger size firms. Furthermore, a $1000 increase in the 6-month average checking account
balance lowers the risk of default by 5.1% for small firms, but by 12.4% for large
firms. These results suggest that smaller size firms behave more like consumer credits,
whereas larger size firms behave more like commercial credits and so bank monitoring
helps account performance. These results are consistent with that of Berger et al. (2005).
Determinants of small business default 3

The rest of the chapter is organized as follows. Section 1.2 discusses the data, method-
ology and summary statistics. Section 1.3 presents the empirical results for small business
defaults by type (Section 1.3.1) and size (Section 1.3.2). Section 4 provides concluding
remarks.

2. Data, methodology and summary statistics

2.1. Data
The data employed in this study are rather unique. The loans and lines are from a single
financial institution and are proprietary in nature. The panel dataset contains over 31 000
small business credits from January 2000 to August 2002.2 The majority of the credits
are issued to single-family owned small businesses with no formal financial records. Of
the 31 303 credits, 11 044 (35.3%) are loans and 20 259 (64.7%) are lines and 25 431
(81.2%) are under $100K and 5872 (18.8%) are between $100K and $250K. The 90-day
delinquency rate for our dataset of loans and lines are 1.6% and 0.9%, respectively. The
delinquency rates for credits under $100K and between $100K and $250K are 1.5% and
0.92%, respectively. It is worth mentioning some of the other key variables of our dataset.
First, our dataset is a loan-level as opposed to a firm-level dataset. More specifically, we
do not have information of all the loans a firm might have with other banks. Second,
because these are small dollar loans, the bank primarily underwrites them based on the
owners’ credit profile as opposed to the firms credit profile. However, the bank does
obtain a firm-specific credit score from one of the credit bureaus (Experian).3 The owner
credit score ranges from 1 to 100 and a lower score is a better score, whereas the firm
credit score ranges from 1 to 200 and a higher score is a better score.

2.2. Methodology
For the purpose of this study, we include all accounts that are open as of January 2000,
and exclude accounts with a flag indicating that the loan is never active, closed due to
fraud/death, bankruptcy and default.4 Furthermore, we also exclude all accounts that
were originated before 1995 to simplify the analysis on account age. We follow the
performance of these accounts from January 2000 for the next 31 months (until August
2002) or until they default.
We use a proportional hazard model to estimate the conditional probability of a small
business defaulting at time t, assuming the small business is current from inception up to
time t − 1. Let Dit indicate whether an account i defaults in month t. For instance, the
business could default in month 24, then Dit = 0 for the first 23 months and Di24 = 1, and
the rest of the observations will drop out of the sample. We define default as two cycles
of being delinquent, as most accounts that are two cycles delinquent (i.e. 60 days past
due) will default or declare bankruptcy. Furthermore, according to the SBRMS report,
57% of banks use the two cycles delinquent as their standard definition of default and
another 23% use one cycle delinquent as their definition of default.5
The instantaneous probability of a small business i defaulting in month t can be written
as follows:

Dit = h0 t exp Xi t (1.1)

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