Expected Default Frequency Model

Unlike us, financial institutions in developed countries use the KMV method of credit monitoring to determine the Expected Default Frequency (EDF).

Since Merton, Black, and Scholes made revolutionary findings in financial theory, particularly in the mathematical valuation of options, it became clear that whenever an organization takes out a loan, it simultaneously buys a “default option.”

In other words, if the business goes well, the LLC pays off the loan and keeps the remaining profit, but if the business goes poorly, it has the right not to repay the loan and instead hand over the assets to the creditors. Similar to trade options, the LLC’s loss range is limited by the obligation, whereas the profit range is not. Therefore, the risk of default is directly related to the volatility of the business’s asset prices.

The KMV Corporation used this simple idea to evaluate default risks and found that the method predicted defaults better than other ratings (see the attached image). In 2002, Moody’s acquired KMV.

Now, let’s see why our banks don’t use this method.

The issue is that in our region, a business’s loss is not limited to its assets. If you want to take out a loan, the founder (shareholder) must act as a guarantor, who also has other businesses and assets. Therefore, there is no “default option” when taking a loan.

What are the results?

1. The banking system doesn’t actually consider risks when issuing loans. Instead, entire incentive systems are built around giving out loans to extremely risky projects. They do have scoring systems to calculate interest rates, but any credit officer will confirm how stressful it is to get a loan approved by a committee with eyes widely shut, just to meet targets. Everyone has forgotten that loans given out with just an ID card led to the bankruptcy of numerous banks in the US and Europe in 2008.
2. An LLC loses its essence if it takes out a loan. Fundamentally, the essence of business development is taking calculated risks. This is why the concept of LLC was created in the first place, and why managers in large corporations in developed countries are incentivized with options. Growth is impossible without taking rational risks. A loan given under a personal guarantee is beyond rational risk. Therefore, the banking system primarily funds “fools” rather than thinkers.

You might think I am exaggerating, but I do not think so, because I know several successful and quite large business CEOs who do not/cannot take loans for this very reason. Business is hindered, while the banking system flourishes.

I believe the harmful practice of requiring personal guarantees must be abolished.

P.S.
If I am wrong, please correct me in the comments…

P.S.

How the KMV EDF Model Works

The model is based on Merton’s Structural Model of Default, which treats a company’s equity as a call option on its assets with debt as the strike price. Default happens when the company’s assets fall below a critical threshold (default point).

Key Inputs to the EDF Model

1. Market Value of Assets (A) – Derived from the market value of equity and the firm’s liabilities.
2. Asset Volatility (σA) – Estimated from equity volatility and capital structure.
3. Default Point (D) – Defined as the short-term debt + a fraction of long-term debt (similar to a financial distress threshold).
4. Distance to Default (DD) – The number of standard deviations between the firm’s asset value and the default point.

DD= [ln⁡(A)−ln⁡(D)] / σA​

5. EDF (Expected Default Frequency) – Translates Distance to Default (DD) into an actual default probability using historical default data. The lower the DD, the higher the EDF.

Source of the idea:

Financial Markets and Institutions – By Anthony Saunders, Marcia Cornett and Otgo Erhemjamts

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