A coherent economic framework to model correlations between PD, LGD and EaD, and its applications in EaD modelling and IFRS-9

This paper proposes an economic framework recognising EaD as a stochastic variable and capturing the PD–LGD, PD–EaD and LGD–EaD correlations. It explains how these correlations can be estimated from historical data, and how PD, LGD and EaD can then be simulated in determining credit VaR. The framework allows credit losses to be more accurately captured, both in terms of the expected credit losses (ECL under IFRS-9 and CECL) and the unexpected …