Incorporating economic outlook into exposure at default models

Wojciech Starosta

Abstract

We propose a novel method of including macroeconomic variables in exposure at default models, which satisfies all expectations connected to International Financial Reporting Standard 9 requirements. In addition, it is intuitive and transparently transforms the situation in the credit environment into expected loss values. We propose a decomposition approach that separates the contract-based variables from the macroeconomic indicators. Using various estimation methods, we build a set of models that combine idiosyncratic information gathered at the exposure level with systematic indicators collected quarterly. We test our predictions on out-of-time data, which includes the Covid-19 pandemic period, and find that our decomposition outperforms benchmarks in terms of selected forecast quality metrics. The proposed solution allows risk managers to adjust capital levels, making their financial institution more competitive in the market.