IMF: financial stress distorts losses in defaults

An IMF paper, published on 1 August, shows inaccurate measurements of probability default at large institutions could lead to misguided policy responses.

Manmohan Singh and Karim Youssef, the paper's authors, say that probability of default measures have been widely used in estimating potential losses and contagion among large financial institutions. In a period of financial stress, however, the existing methods may yield accurate results.

The authors discuss three issues that should be taken into account when using probability of default based methods for calculating losses or contagion analyses. First, they compare risk-neutral probabilities to a real-world probabilities; second, they look at the divergence between movements in credit and equity markets during periods of financial stress; and finally, they consider what implications the assumptions of stochastic and fixed recoveries have for financial institutions' assets.

Singh and Youssef argue that during periods of stress, measures for the probability of default of financial institutions should be adjusted downward to arrive at the real world probabilities, as some of the assumptions underlying the models may become tenuous in a crisis. They argue that failure to fully account for these elements may result in different, and perhaps misguided results and policy recommendations.

Click here to read the paper