Modeling Rating Transition Matrices for Wholesale Loan Portfolios

Risk analysis of a commercial bank's wholesale loan portfolios involves modeling of the asset quality ratings of each borrower's obligations. This customarily involves transition matrices which capture the probability that a loan's AQ rating will migrate to a higher or lower rating, or transition to the default state. We compare and contrast three approaches for transition matrix modeling: the single factor approach commonly used in the financial industry, an approach based on time-series forecasts of default rates, and an approach based on modeling selected elements of the transition matrix which comprise the most likely outcomes. We find that these two unorthodox approaches both have excellent performance over a sample period encompassing the financial crisis.