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Basel III seeks to improve the financial sector's resilience to stress scenarios which calls for a reassessment of banks' credit risk models and, particularly, of their dependence on business cycles. This paper advocates a Mixture of Markov Chains (MMC) model to account for stochastic business cycle effects in credit rating migration risk. The MMC approach is more efficient and provides superior out-of-sample credit rating migration risk predictions at long horizons than a naïve approach that conditions deterministically on the business cycle phase. Banks using the MMC estimator would counter-cyclically increase capital by 6% during economic expansion and free up to 17% capital for lending during downturns relative to the naïve estimator. Thus, the MMC estimator is well aligned with the Basel III macroprudential initiative to dampen procyclicality by reducing the recession-versus-expansion gap in capital buffers.

This paper investigates whether gender-diverse boards can play a role in preventing costly bank misconduct episodes. We exploit the fines received by European banks from US regulators to reduce endogeneity issues related to supervisory and governance mechanisms. We show that greater female representation significantly reduces the frequency of misconduct fines, equivalent to savings of $7.48 million per year. Female directors are more influential if they reach a critical mass and are supported by women in leadership roles. The mechanism through which gender diversity affects board effectiveness in preventing misconduct stems from the ethicality and risk aversion of the female directors, rather than their contribution to diversity. The findings are robust to alternative model specifications, proxies for gender diversity, reverse causality, country and bank controls, and sub-sample analyses.