Probability of default (PD)
Probability of default is the likelihood that a borrower defaults over a given horizon, usually one year. Capital models use a long-run average (through-the-cycle) PD per rating grade, while IFRS 9 uses point-in-time 12-month and lifetime PDs that react to the economic outlook.
Roles that need it
What it is
Probability of default (PD) is the likelihood that a borrower will default within a set period. Default follows the CRR definition: more than 90 days past due on a material obligation, or unlikely to pay. Banks rarely estimate PD for each borrower directly. A rating model or scorecard assigns the borrower to a grade, and each grade carries a PD.
Two views of PD exist. A through-the-cycle (TTC) PD is a long-run average default rate for a grade across good and bad years; it is used for regulatory capital under the internal ratings based approach. A point-in-time (PIT) PD reflects current and expected conditions; IFRS 9 uses it, both for 12 months and for the whole life of the loan.
Why it matters
PD is the first input of capital, provisions, pricing and limits. A small change in PD calibration moves risk-weighted assets and expected credit loss across a whole portfolio. For that reason EBA guidelines set detailed rules on data, the long-run average, margins of conservatism and annual review, and the CRR sets a floor of 0.05 percent for most exposures.
Worked example
Illustrative numbers. A bank’s grade 5 holds 1,000 corporate borrowers at the start of the year. During the year 18 of them default, an observed default rate of 1.8 percent.
Over the last ten years the yearly default rate for grade 5 averaged 2.1 percent, ranging from 0.9 percent in a good year to 4.5 percent in a recession. The TTC PD for capital starts from the 2.1 percent long-run average, plus a margin of conservatism for data gaps, say 0.3 percentage points, giving 2.4 percent. For IFRS 9, the bank adjusts the long-run curve with its macroeconomic outlook; with a mild downturn forecast, the 12-month PIT PD might be 2.8 percent.
Who uses it
- Credit Risk Model Developers build rating models and calibrate PDs to default history.
- Model Validation Analysts test calibration and ranking through backtesting.
- Credit Risk Analysts and Corporate Credit Analysts use grades and PDs in credit decisions and annual reviews.
- Regulatory Reporting Analysts report PD bands in COREP and Pillar 3.
- Data Scientists (Banking) work on the data pipelines and challenger models.
Common confusions
- A PD is a forecast for a group of similar borrowers. An individual borrower either defaults or does not.
- The observed default rate in one year is evidence for calibration. It is rarely the PD itself.
- External agency ratings and internal grades can be mapped to each other, and their default definitions and horizons may differ.
- TTC and PIT are ends of a range. Most models sit somewhere between, and IFRS 9 PDs are often derived from capital PDs with adjustments.