This paper evaluates empirically the performance of six structural credit risk
models by comparing the probabilities of default (PDs) they deliver to ex post
default rates. In contrast to previous studies pursuing similar objectives, the
paper employs firm-level data and finds that theory-based PDs tend to match
closely the actual level of credit risk and to account for its time path. At
the same time, nonmodelled macro variables from the financial and real sides of
the economy help to substantially improve the forecasts of default rates. The
finding suggests that theory-based PDs fail to fully reflect the dependence of
credit risk on the business and credit cycles. Most of the upbeat conclusions
regarding the performance of the PDs are due to models with endogenous default.
For their part, frameworks that assume exogenous default tend to underpredict
credit risk. Three borrower characteristics influence materially the
predictions of the models: the leverage ratio; the default recovery rate; and
the risk-free rate of return.
JEL Classification Numbers: C52, G1, G3
Keywords: Probability of default, Credit risk models, Basel II, Macroeconomic
factors of credit risk
