TransferRisk_JCreditRisk

The Journal of Credit Risk (37–51) Volume 7/Number 2, Summer 2011
Transfer risk under Basel Pillar 1
Amit Agarwal
Group Portfolio Risk, Standard Chartered Bank,
Marina Bay Financial Centre (Tower 1), 8 Marina Boulevard,
018981, Singapore; email: amit.agarwal@sc.com
Paul Harrald
018981, Singapore; email: paul.harrald@sc.com
Yin Yee Kan
018981, Singapore; email: kan.yin-yee@sc.com
Peter Thompson
018981, Singapore; email: peter.thompson@sc.com
All else being equal, debt obligations in local and foreign currencies to the same
obligor carry different default risk. The incremental default risk on a foreign-
currency obligation is due to transfer risk: the risk that a government will impose
controls on the transfer or convertibility of the foreign currency required for
private-sector debt servicing. The Basel framework allows for transfer risk to be
capitalized using the internal ratings-based approach under Pillar 1, although it
does not actually require it. We derive formulas that allow for a transaction-level
adjustment of the default probability.
1 INTRODUCTION
1.1 Overview
Transfer risk is the risk that a government will impose a moratorium on, or otherwise
prohibit, a private-sector obligor from servicing their foreign-currency debt obliga-
TheopinionsexpressedhereinarethoseoftheauthorsanddonotnecessarilyreﬂectthoseofStandard
Chartered Bank. The authors are grateful to Gregory Vargas and to the anonymous reviewers for
their constructive feedback.
37

38 A. Agarwal et al
tions.1
It is an inherent, if not always material, element of the credit risk in a significant
proportion of international cross-border lending.
The Basel framework allows for different credit risk grades to be assigned to a
single obligor, where that obligor has separate exposures in local and foreign currency
(European Union (2006,AnnexVII, Part 4, Section 23)).2
For reasons we discuss later
in this paper, this is not often done in practice for very many obligors. However, it
does leave open the possibility, without requiring it, to calculate regulatory capital
for transfer risk using the internal ratings-based approach under Pillar 1.
In this paper we develop the idea originally proposed by Pluto and Tasche (2006)
of adjusting the obligor’s default probability (PD) to take account of transfer risk,
extending their work in two ways. First, we relax the assumption, implicit in their
derivation, that transfer events must necessarily cause default. Second, we accommo-
date the possibility that the initial default probability assigned to an obligor based on
their credit risk grade, PDo, may or may not already include transfer risk. Our result
is two distinct adjustment formulas, which take an initially assigned PDo and then,
dependent on whether the exposure is denominated in local or foreign currency, output
the corresponding default probability (PDLCY or PDFCY) adjusted for transfer risk.
The adjustment formulas are risk-sensitive since they are based on assessments of
the transfer-event probability in the relevant country and also on the obligor’s default
probability given a transfer event. We present examples to show how the difference
between an obligor’s PDLCY and PDFCY will widen as a country crisis evolves.
1.2 Transfer risk
Countries pay for the bulk of their imports in foreign currency. Maintaining sufficient
reserves is thus important, especially for emerging-market countries where import
requirements can be particularly inelastic. The consequences of failing to keep ade-
quate reserves, coupled with weak economic fundamentals, can result in a downward
spiral, worsened by possible speculative attacks on the local currency or a run on
1 We refer throughout this paper to a transfer event as being the realization of transfer risk.
2 See also Financial Services Authority (2008, Section 4.4.13), which states:
Separate exposures to the same obligor shall be assigned to the same obligor grade,
irrespective of any differences in the nature of each specific transaction. Exceptions,
where separate exposures are allowed to result in multiple grades for the same obligor
[include] country transfer risk, this being dependent on whether the exposures are
denominated in local or foreign currency.
We note that the initial draft of Capital Requirements Directive 4, which in final form will implement
Basel III, makes no change to the Basel II legislation in regard to this or to the various other sections
to which we refer in this paper.
The Journal of Credit Risk Volume 7/Number 2, Summer 2011

Transfer risk under Basel Pillar 1 39
banks. Governments facing such a predicament will often resort to various measures
to stem the tide of foreign-currency outflows, including banning inessential imports
(eg, India in 1991), limiting withdrawals of foreign-currency deposits (eg, Mexico in
1983) or mandating the surrender of export earnings (eg,Argentina in 2001–2). These
examples are neither exhaustive nor unique in their occurrence, but represent the sort
of events or government actions that are broadly described by the term country risk.3
If the situation deteriorates enough, a government may have no choice but to forgo or
reschedule its own foreign debt payments; this is sovereign risk. Additionally, where
private-sector (nonsovereign) foreign debt repayments constitute a material propor-
tion of the country’s outflow, the government may prohibit such debt servicing; this
is transfer risk.
A key aspect of transfer risk is that it affects obligors who are otherwise willing
and economically able to meet their debt obligations. The presence of transfer risk
thus means that a debt obligation in foreign currency (FCY) has a higher default risk
than an otherwise equivalent obligation to the same obligor in local currency (LCY).4
Apart from a single reference to transfer risk, and the allowance for assigning
different credit risk grades, the Basel framework is silent on both the definition of
“country transfer risk” and the criteria for its assessment. The Banking Consolidation
Directive does, however, contain a wide-ambit requirement that “a rating system shall
take into account obligor and transaction risk characteristics” (see European Union
(2006, Annex VII, Part 4, Section 5)).5
While it is clear that the Basel framework
does not actually require that transfer risk be capitalized for unexpected loss under
3 Country risk as a concept covers a wide range of risks and events including sovereign default,
transfer risk, banking crises (widespread bank runs), currency crises, all manner of possible gov-
ernment prohibitions on legal contractual compliance, forced expropriation, etc, as well as events
such as civil or political unrest, external aggression or even natural disasters.
4 For present purposes, “foreign currency” means a currency other than the local (or domestic)
currency of the country of the obligor or the country in which a deal is booked.
5 See also Financial Services Authority (2008, Section 4.4.6), which replaces the word “shall” with
“must”. The New Basel Capital Accord, a consultative document released as a precursor to the
Basel II legislation, is more elaborative in this regard. It explicitly includes in the risk assessment
of a borrower (Bank for International Settlements (2001b, p. 50)):
the risk characteristics of the country [the borrower] is operating in, and the impact
on the borrower’s ability to repay (including transfer risk), where the borrower is
located in another country and may not be able to obtain foreign currency to service
its debt obligations.
In an accompanying document released alongside Bank for International Settlements (2001b), the
Basel Committee states (see Bank for International Settlements (2001a, p. 11)):
Country (transfer) risk is almost universally considered a risk factor in the rating
assignment process for crossborder lending.
Research Paper www.journalofcreditrisk.com

40 A. Agarwal et al
Pillar 1,6
the implication from both the legislation as well as the precursor documents
is that it is a transaction-level risk, and is therefore amenable, in principle, to internal
ratings-based treatment.
1.3 Challenges for an internal ratings-based treatment of
transfer risk
The most immediate difficulty confronting any attempt to consider transfer risk in a
quantitative framework is the infrequency of its historical occurrence. Transfer events
havebecomeincreasinglyrare,withperhapslessthanhalfadozeninthepastdecadeor
so.7
The reasons for this are not the subject for detailed discussion in this paper, except
to make the observation that the costs of suppressing private-sector debt servicing
invariably outweigh the benefits. Additionally, globalization and the liberalization of
capital controls and financial transactions have meant that governments today have
a lower administrative capacity for enforcing strict moratoria. Likewise, financial
innovations have created greater scope for private obligors to avoid the effects of
controls.
In the midst of a country crisis, default levels on both local- and foreign-currency
obligations will generally rise. Pure “transfer risk defaults”, where the default would
not otherwise have happened but for the imposition of transfer controls, are not as
common as might be surmised (Standard & Poor’s (2009)). During a crisis, transfer
events can often occur either contemporaneously or in close succession with wide-
spread bank runs, collapsing currency exchange rates or sovereign default.8
Consid-
ering the fact that the general economic health of a country in crisis will often be dire,
the identification of the precise cause leading to any individual default can often be
very difficult.
Given the points we raise above, a transfer risk “model”, built from and calibrated
to empirical data, is not really feasible at the current point in time. What we propose is
more in the nature of an approach, with parameters in the adjustment formulas being
determined semiempirically or from constrained expert judgment.
6 At least one European regulator, the UK’s Financial Services Authority, has stated in public com-
munication its view that transfer risk is one of the “risks not covered by Pillar 1” (Financial Services
Authority (2006, Section 4.11)).
7 Although it is conceivable that some short-lived transfer events may not become known in the
public domain, the following are five recognized occurrences in the past fifteen years: Russia
(1998), Ecuador (1999), Pakistan (1999), Argentina (2001–2) and Venezuela (2003).
8 Argentina in 2001–2 endured a default on sovereign debt, a banking crisis (with widespread runs on
banks), the depegging and severe devaluation of the peso, as well as several intermittently applied
transfer events (including a moratorium on transfer and forced conversion of FCY debt to LCY
debt) (see Lopez (2002a,b)).

FIGURE 1 The marginal default probability due to transfer risk.
D
DX
DT
A
T
2 AN APPROACH FOR THE ADJUSTMENT OF DEFAULT
PROBABILITIES
The default probability assigned based on an obligor’s risk grade, PDo, will reﬂect the
stand-alone obligor characteristics. If there is no difference in the risk grade assigned
to the obligor based on the currency of the exposure, then local- and foreign-currency
exposures to the same obligor will be assigned the same default probability, PDo. We
derive formulas for making an adjustment to PDo. The adjustment will depend on
whether the underlying exposure is denominated in foreign or local currency, to give
either PDFCY or PDLCY, respectively, as the new default probability. The adjustment
is risk-sensitive, in that as the assessment of the transfer-event probability changes
over time, so will the difference between PDFCY and PDLCY.
The starting point for our derivation is the short note by Pluto andTasche (2006).We
expand upon the derivation they provide by relaxing some of their implicit assump-
tions.ConsiderthediagraminFigure1,withtheoverlapofdifferentareasrepresenting
the contemporaneity of events.
The areas shown in Figure 1 can be interpreted as follows:
T is a transfer event in a given country;
D D DX
C DT
is the total combined rectangular area and represents a default
event;
DX
represents a default due to any reason except a transfer event;
DT
represents a default due to a transfer event;
A is the area of overlap between DX
and T , and it represents those defaults that
occur contemporaneously with a transfer event but that are causally unrelated.

42 A. Agarwal et al
With P.T / denoting the probability of a transfer event and P.D=T / the conditional
defaultprobabilitygiventheoccurrenceofatransferevent,thetotaldefaultprobability
P.D/ can be written:
P.D/ D P.DX
/ C P.DT
/
D P.DX
/ C P.T /P.D=T / P.T /P.DX
/
D P.DX
/ C P.T /ŒP.D=T / P.DX
/ (2.1)
It is clear from Figure 1 on the preceding page that P.D/ > P.DX
/, which implies
that P.D=T / > P.DX
/. P.D=T / is bounded above by 1, meaning default with
certainty in a transfer event, and bounded below by P.DX
/, in which case the default
probability is unaffected by transfer risk.
If we make the further assumption that transfer risk is the only differential element
between local- and foreign-currency default risk,9
then we can write:
PDLCY D P.DX
/; PDFCY D P.D/ (2.2)
and Equation (2.1) simply becomes:
PDFCY D PDLCY C P.T /ŒP.D=T / PDLCY (2.3)
Equation (2.3) is the result that Pluto and Tasche would achieve if their implicit
assumption of default certainty in a transfer event, P.D=T / D 1, was relaxed.10
We now go one step further by allowing for the possibility that the default prob-
ability assigned to an obligor based on their credit risk grade, PDo, may or may not
already include transfer risk.11
Let us denote by an inclusion factor, 0 6 W 6 1, the
degree to which transfer risk may already be included in PDo. So we have:
W PDFCY C .1 W /PDLCY D PDo (2.4)
9 We acknowledge that there are various facets of country risk, besides transfer risk, that clearly
have a differential impact on local- and foreign-currency default probabilities. Transfer risk implies
a strictly monotonic increase in default risk for similar obligations in local and foreign currencies,
although this is probably not the case for all aspects of country risk in general, eg, civil unrest or
even war could conceivably have a more deleterious effect on local-currency default probabilities
(see Section 4 of this paper).
10 Equation (2.3) can be recovered from Pluto and Tasche’s derivation on p. 3 of their paper as
follows: replace P.T / with P.T /P.D=T / and rename P.D [ T / as PDFCY and P.D=T C/ as
PDLCY.
11 Such inclusion is probably unusual in practice, but if included, may be inherent ex post, because the
calibration dataset may have included data from periods in which transfer events have taken place,
or it may be included ex ante, with the risk grade having been determined based on forward-looking
assessments of transfer risk, at the inception of a loan.

Combining Equations (2.3) and (2.4) gives the desired risk-sensitive adjustment for-
mulas:12
PDFCY D
PDo.1 P.T // C .1 W /P.T /P.D=T /
1 WP.T /
(2.5a)
PDLCY D
PDo WP.T /P.D=T /
1 WP.T /
(2.5b)
Equations (2.5a) and (2.5b) allow for the default probability assigned based on an
obligor’s risk grade, PDo, to be adjusted according to exogenous inputs (P.T /,
P.D=T / and W ) to output PDFCY or PDLCY, as appropriate to the exposure. The
output default probability can then be input to regulatory-capital, expected-loss and
economic-capital calculations.
3 PARAMETER VALUES
3.1 Crisis default probability, P.D=T /
When transfer controls are imposed, they are sometimes of a short enough duration
that only those obligors already distressed13
will fall into technical default. This is
one of the reasons which prompted us to relax the assumption of certain default in
the derivation of the PD adjustment formulas. However, there are other reasons to
suppose that P.D=T / < 1.
Any default probability is an obligor-level parameter. In a transfer event, not all
private-sector obligors are “equal”. It is sometimes the case that trade ﬁnance or other
strategically important industries will be exempted, at least to some extent, from
blanket moratoria (this was the case in Russia in 1998 and inArgentina in 2001–2, for
example). For such companies, and possibly those obligors to whom a bank has very
large foreign-currency exposures, there may well be value in a deep-dive analysis to
determine a value of P.D=T / at the level of the individual obligor. Doing so for all
obligors, however, is clearly impractical.
As an alternative, we propose that P.D=T / could be assumed to be a simple
multiple of PDo, of the form:
P.D=T / D min.100%; K PDo/ (3.1)
Empirical estimates of the multiplier (K) can be made by comparison of crisis and
noncrisis default rates (see, for example, Duggar et al (2009)).14
K could feasibly be
estimated at country level.
12 We note again that Equations (2.5a) and (2.5b) would be recovered via the Pluto and Tasche
derivation if their implicit assumption of W D 0 was relaxed (in addition to the points we made in
footnote 10).
13 Distressed here meaning past due for a period less than ninety days.
14 Most banks would probably take into account their own internal default data.

44 A. Agarwal et al
Equation (2.3) shows that the difference between PDFCY and PDLCY is determined
by two parameters:
(i) the relevant country’s transfer-event probability, P.T /, and
(ii) the difference between the default probabilities with and without the occurrence
of a transfer event.
If P.D=T / takes the form of Equation (3.1), then the magnitude of the PD adjustment
for transfer risk, relative to the default probability without transfer risk, PDLCY, is
shown to be proportional to the transfer-event probability P.T / and the multiplier
K:15
PDFCY PDLCY
PDLCY
D
P.T /ŒP.D=T / PDLCY
PDLCY
D
P.T /PDLCYŒK 1
PDLCY
/ P.T /K
(3.2)
3.2 Transfer-event probability, P.T /
The transfer-event probability, P.T /, is assigned at a country level. The starting
point to obtain a numerical probability is to assign a transfer risk grade, and it is not
uncommon for this to be done by “notching” from the sovereign risk grade, using
the same rating scale.16
A transfer risk grade assigned in this manner clearly has an
inherent element of professional judgment, although there are clear criteria that can
be used as guidelines in making notching assessments.17
In the absence of a sovereign
rating from which to notch (for example, many smaller, emerging-market countries
do not issue publicly traded sovereign debt), an assessment of the transfer risk grade
might be made along similar lines as risk grades for corporate borrowers.
One way or another, a value for the transfer-event probability needs to be assigned.
Wenotethattransferriskgradesassignedbytheagenciesareprimarilyarank-ordering
metric, and the agencies are careful to point out that they do not associate their transfer
risk grades with event probabilities.18
15 We have taken P.D=T / D K PDLCY, which equates PDo to PDLCY. In terms of Equations
(2.5a) and (2.5b), this just assumes that W D 0, although the same general result falls out assuming
W D 1.
16 For example, Standard & Poor’s sets their transfer and convertibility (T&C) ratings for a country
by “notching”, according to deﬁned criteria, from the sovereign ratings (see Standard & Poor’s
(2009)).
17 Criteria used for assessment of transfer risk by each of the three main rating agencies are set out
in Moody’s (2006), Fitch (2008) and Standard & Poor’s (2009).
18 As part of this research, a standardized questionnaire was sent to Moody’s, Standard & Poor’s and
Fitch.Among the questions on the survey was whether they assign numerical values to transfer-event
probabilities.

3.3 Inclusion factor, W
Where a single default probability PDo is assigned for each obligor, the inclusion
factor W in Equations (2.5a) and (2.5b) determines whether and how PDo will be
adjusted. W is a static, rather than variable, parameter, and it would be set according to
the framework by which credit risk grades are assigned. For most banks and ﬁnancial
institutions it is unlikely in practice that transfer risk is considered when assigning
credit grades, in which case W D 0.
W D 0 means transfer risk is not inherently included in the assigned PDo, hence:
PDo is increased for FCY exposures, to include the transfer risk element; and
PDo is unchanged for LCY exposures, as these bear no transfer risk.
W D 1 means transfer risk is already inherently included in the assigned PDo,
hence:
PDo is unchanged for FCY exposures, since transfer risk is already included;
and
PDo is decreased for LCY exposures, to extricate the transfer risk element.
4 DISCUSSION
4.1 Examples
The deteriorating economic environment as a country crisis evolves will generally
mean that most obligor default probabilities will increase, LCY and FCY obligations
alike. The adjustment equations (2.5a) and (2.5b) allow the magnitude of the differ-
ence between FCY and LCY default probabilities to increase along with transfer risk.
This is shown schematically in Figure 2 on the next page.
Figure 3 on page 47 and Figure 4 on page 48 provide a more concrete exam-
ple. Each shows the increase in transfer-event probability and the resultant widening
between local- and foreign-currency PDs over the twelve months prior to Argentina’s
sovereign default (November 2001) and subsequent imposition of transfer controls
(December 2001).
Figure 3 on page 47 considers a hypothetical obligor whose assigned PDo D
PDLCY
19
stays constant at 200 basis points (bps) throughout the twelve months over
which the sovereign ratings (and, by implication, country transfer ratings) deteriorate.
19 That is, we assume here that the default probability assigned based on the obligor’s credit risk
grade does not have transfer risk included (W D 0) and hence is equivalent to the local-currency
default probability, PDLCY.

46 A. Agarwal et al
FIGURE 2 Widening of FCY and LCY default probabilities as a country crisis unfolds.
0
5
10
15
20
25
30
35
Probabilityofdefault(%)
Time
PDFCY = 1.2%
PDLCY = 1.0%
Evolving country risk crisis
Benign
P (T ) = 0.5%
PDFCY
PDLCY
PDFCY = 28%
PDLCY = 20%
Widening
difference
Crisis
P (T ) = 10%
Default and transfer-event probabilities are indicative only, but are typical of a mid-quality corporate borrower in an
emerging-market country. Calculations use Equations (2.5a), (2.5b) and (3.1) with values W D 0 and K D 50.
Figure 4 on page 48 presents a more realistic scenario where the obligor risk grade
is assumed to be the same as, and to deteriorate along with, that of the sovereign.
The ﬁgure shows the double impact of the worsening PDLCY as well as the widening
magnitude between PDFCY and PDLCY.
For Figure 3 on the facing page and Figure 4 on page 48 we have assumed that
the country transfer rating is the same as the sovereign rating. This “zero notch”
assumption is not uncommon for emerging-market countries. We have chosen to
use Standard & Poor’s sovereign ratings, although we observe that Moody’s and
Fitch also showed similar declines in their sovereign rating for Argentina over the
course of 2001. From the Standard & Poor’s ratings, we make our own assessment of
the corresponding transfer-event probabilities, P.T /. For the calculations underlying
these graphs, we have chosen to use a multiplier of K D 10, ie, that the assigned
default probability of every obligor increases ten times given a transfer event. This
value of K we consider to be not implausible for many emerging-market countries.20
20 This is broadly consistent with the numbers reported in Duggar et al (2009), although we recognize
that the multiplier is not necessarily a purely empirical parameter.

FIGURE 3 Evolution of LCY and FCY default probabilities in the period leading up to
Argentina’s transfer event: constant PDLCY D 200bps.
19.6%
9.4%
6.5%
4.6%
3.5%
3.1%
2.7%
2.0%2.0%2.0%2.0%2.0%2.0%2.0%
CCC+
B−
B
B+
BB−
BB
100%
10%
1%
10/01/00 11/01/00 11/14/00 03/26/01 05/08/01 07/12/01 10/09/01 10/30/01 11/30/01
PDFCY
PDLCY
CC
Sovereign S&P ratings
PD shown on a log scale.
4.2 Other dimensions to country risk
The adjustment formulas have been derived by assuming that transfer risk is the only
factor that affects the risk proﬁle of an FCY obligation over and above that of an
equivalent LCY obligation, to the same obligor. For separate obligations to the same
obligor, this is a reasonable assumption. A deﬁning characteristic of a “transfer risk
default” is the fact that the obligor is willing and otherwise economically able to pay.
Default for any other reason invariably arises when the obligor becomes economically
unviable.
More broadly, however, and certainly beyond the contemplation of the Basel frame-
work, let us now consider the more general case of a pool of obligors with similar
characteristics, some with local-currency and others with foreign-currency obliga-
tions. In this case, other elements of country risk come into play to cause a differential
impact on the default risk of obligors within the pool. For example, exchange-rate
risk (ie, the risk of severe and relatively sudden depreciation of the local currency

48 A. Agarwal et al
FIGURE 4 Evolution of LCY and FCY default probabilities in the period leading up to a
transfer event: deteriorating PDLCY.
100.0%
35.1%
15.1%
6.2%
2.7%
1.8%
0.9%
18.0%
7.5%
4.6%
2.7%
1.5%
1.2%
0.7%
CC
CCC+B−
B+
BB−
1000%
1%
0.01%
10/01/00 11/01/00 11/14/00 03/26/01 05/08/01 07/12/01 10/09/01 10/30/01 11/30/01
100%
10%
0.1%
BB
B
PDFCY
PDLCY
Sovereign S&P ratings
PD shown on a log scale.
against the debt currency) occurs with greater frequency, and is more often a cause
of default,21
than transfer risk.22
Civil unrest or even civil war, to take a different
example of a “country risk”, may have more of an incremental impact on the default
risk of local-currency, rather than foreign-currency, obligations.23
Banks will often consider country risk, in its broader sense, as part of the process of
assigning credit risk grades, in which case it will be inherently included in the credit
risk capital. To the extent that this is not the case, however, our view is that it would
21 The problem arises when a borrower gets caught out using local-currency earnings to service the
foreign-currency debt. This was a cause of many defaults in the Asian crisis (1997–8).
22 To the extent that driving factors such as a country’s foreign reserve levels are relatively trans-
parent, exchange-rate risk is also more visible, as well as being potentially easier to “model”, using
methods proposed, for example, in Van der Burgt (2004, 2005).
23 We are grateful to one of the anonymous reviewers of an early draft of this paper for bringing this
intriguing possibility to our attention.

be difficult to assign incremental regulatory capital for country risk at transaction
level, as Pillar 1 requires. We interpret the fact that the Basel framework makes no
explicit reference to any other aspect of country risk as a tacit acknowledgement of
the difficulty of doing so.
This may not be an issue of prudential concern: some elements of country risk,
such as exchange-rate risk, can be mitigated to a considerable extent at the inception
of a loan, eg, prudent lending practice would restrict the debt currency to either
the obligor’s main earning currency, or alternatively to the collateral currency. And
there are often mitigating actions that banks can take, such as reducing exposures
or restructuring debt obligations, in the lead-up period as country crises evolve.24
Forward mitigation is more prudent than, and preferable to, setting aside additional
regulatory capital for unexpected losses.
4.3 Interpretation of dual ratings where they exist
The allowance provided within the Basel legislation for assigning different risk grades
to local- and foreign-currency exposures to the same obligor is rarely availed of by
banks. The main reason for this is because the PD increase that results from moving
to a separate risk grade can often be larger than one might prudently consider is
necessary to reflect the inclusion of transfer risk. For the typical rating scales used
internally by banks or rating agencies, the midpoint PDs associated with successive
risk grades increase roughly log-linearly across a scale spanning perhaps fifteen to
thirty notches from best to worst. The best grades are associated with a PD in the range
of a few basis points while the worst will have a PD typically around 3000bps or more.
As a consequence, the increase in PD associated with assigning a foreign-currency
exposure to a grade even just one notch higher than for a local-currency exposure to
the same obligor can be quite large. We note that the magnitude of the PD adjustment
from the formulas we propose in this paper (Equations (2.5a) or (2.5b)) is in many
(although by no means all) cases small enough that the adjusted PD remains within
the range of the original credit risk grade.25
Ratings agencies sometimes assign different local- and foreign-currency ratings to
nonsovereign obligors.26
In the context of the approach we present in this paper, the
notch difference between a local- and foreign-currency rating for a particular obligor
is dependent both on an assessment of a government’s propensity to impose transfer
24 There was a 12–18 month period preceding the sovereign default in Argentina where banks could
and did avail themselves of opportunities to reduce exposure and restructure debts.
25 This would typically arise, for example, with a sub-investment-grade obligor who is incorpo-
rated/domiciled in an investment-grade country. In such a case, the obligor retains the same credit
risk grade for local- and foreign-currency exposures, but has a different PD.
26 At least those obligors who issue public debt in local and foreign currencies.

50 A. Agarwal et al
moratoria, P.T /, and on an assessment of how well a particular obligor may be able to
makepaymentsdespitesuchimposition,P.D=T /.Inprinciple,basedonthehistorical
default rates that the agencies assign to their respective ratings, Equation (2.3) could
be used to estimate a value, or an upper bound to the value, of P.D=T / or P.T /, each
given the other. Despite the general paucity of obligors to whom the agencies assign
dual ratings, and the very rare occurrence of selective default by nonsovereigns, this
may be an avenue worthy of further investigation. However, we note that:
(i) both P.T / and P.D=T / are parameters that necessarily have an element of
professional judgment in the determination of suitable, forward-looking values;
and
(ii) the notch difference between dual ratings assigned by the agencies will often
take into account other aspects of country risk, besides transfer risk.27
5 CONCLUSION
In this paper we have derived formulas for adjusting an obligor’s default probability to
take into account the differential impact of transfer risk on local- and foreign-currency
exposures. The magnitude of the adjustment is proportional to the transfer-event prob-
ability for the relevant country, as well as an estimate of the obligor’s default probabil-
ity given a transfer event. For implementation within a bank’s internal ratings-based
Pillar 1 framework, where the adjustment needs to be made for every transaction that
bears transfer risk, we propose that the default probability in a transfer event be taken
as a linear multiple of the normal default probability based on the obligor’s assigned
credit risk grade. The multiplier could be based on a country or regional assessment of
the scaling multiple between crisis and noncrisis default probabilities. Our formulas
also make allowance for whether the original default probability assigned on the basis
of the obligor’s credit risk grade already includes transfer risk.
REFERENCES
Bank for International Settlements (2001a). The internal ratings-based approach. Report
(January). URL: www.bis.org/publ/bcbsca05.pdf.
Bank for International Settlements (2001b). New Basel Capital Accord. Basel Committee
on Banking Supervision (January). URL: www.bis.org/publ/bcbsca03.pdf.
27 Note that Trevino and Thomas (2001), who sought to examine the information content in the notch
difference between local- and foreign-currency ratings, only considered sovereigns. In the context
of their work, they consider “transfer risk” to be the risk of sovereign default on foreign-currency
debt. There is of course considerably more depth to the historical data associated with selective
sovereign default than there is for nonsovereigns.

Duggar, E., Emery, K., Gates, D., Carpenter, A., Lemay,Y., and Cailleteau, P.(2009).Emerg-
ing market corporate and sub-sovereign defaults and sovereign crises: perspectives on
country risk. Report, Moody’s Global Credit Policy (February).
European Union (2006).Banking consolidation directive.Directive 2006/48/EC.URL: http://
eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2006:177:0001:0001:EN:PDF.
Financial Services Authority (2006). Strengthening capital standards 2. Consultation
Paper CP06/3. URL: www.fsa.gov.uk.
Financial Services Authority (2008). The prudential sourcebook for banks, building soci-
eties and investment ﬁrms. Report FSA 2006/41. URL: www.fsa.gov.uk.
Fitch (2008). Country ceilings. Report, Fitch Ratings (September).
Lopez, C. (2002a).The Argentine crisis: a chronology of events after the sovereign default.
Report, Standard & Poor’s RatingsDirect (April).
Lopez, C. (2002b).The Argentine crisis: chronology of events after sovereign default since
April. Report, Standard & Poor’s RatingsDirect (June).
Moody’s (2006). Revised foreign-currency ceilings to better reﬂect reduced risk of a pay-
ments moratorium in wake of government default. Report, Moody’s Rating Methodology
(May).
Pluto, K., and Tasche, D. (2006). A short note on transfer risk. Working Paper. URL: http://
ssrn.com/abstract=969813.
Standard & Poor’s (2009). Methodology: criteria for determining transfer and convertibility
assessments. Report, Standard & Poor’s RatingsDirect (May).
Trevino, L., and Thomas, S. (2001). Local versus foreign currency ratings: what determines
sovereign transfer risk? Journal of Fixed Income 11(1), 65–76.
Van der Burgt, M. (2004). Calculating transfer risk using Monte Carlo. Risk 17(1), 81–85.
Van der Burgt, M. (2005). A Merton approach to transfer risk. Risk 18(9), 110–114.

TransferRisk_JCreditRisk

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Viewers also liked

Viewers also liked (10)

Similar to TransferRisk_JCreditRisk

Similar to TransferRisk_JCreditRisk (20)

TransferRisk_JCreditRisk