Detangling Financial Risk From Business Risk In A Probability Of Default (PD) Model
The ability of corporations to conduct their business and access funding has dramatically weakened amid ongoing global financial market turmoil on an unprecedented scale. Following the so-called "credit crunch," banks have substantially and steadily decreased available liquidity for loans in North America and Europe, despite historically low central bank interest rates and a multitude of stimulus efforts in the affected economies.
Facing such a prolonged funding dilemma, even large private companies (such as NewPage Corp, or Real Mex Restaurants Inc., to name a few) have defaulted on their credit obligations. At the same time, some were forced to choose between going into administration or filing for bankruptcy. However, most existing probability of default (PD) models that external vendors or internal risk functions in corporate and financial companies developed failed to adequately capture the marked increase in default rates and to clearly distinguish between creditworthy and distressed companies. This exacerbated the credit crunch, and therefore the risk of default, in a vicious spiral.
In such a challenging environment, it would be insufficient to merely go back to basics, such as solely relying on company financial fundamentals. This is because business risk has become equally important. While quantitative models available in the market do not usually include business risk in an explicit manner, this risk includes valuable information about the economic environment in which the company operates, as well as company-specific elements related to its competitiveness and its management quality.In light of these conditions, a PD model that incorporates both financial risk and business risk and clearly distinguish them from each other is extremely desirable to any risk management function. S&P Global Market Intelligence's PD Model Fundamentals - Private Corporates provides a comprehensive overview of a company's creditworthiness, while enabling its users to identify and distinguish the real sources of risk.