Credit Rating Migration Risk and Business Cycles

Abstract

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.

The Probability of Default Under IFRS 9: Multi-period Estimation and Macroeconomic Forecast

“…The second popular approach is based on the survival analysis framework. For example Duffie et al (2007) Fei et al (2012) and Gavalas, Syriopoulos (2014) utilize this framework to analyse the relationship between transition probabilities (including default probabilities) and business cycles. Given the main objective of this paper, it is not directly comparable with the mentioned studies.…”

Business Cycle And Changes On The Financial Market – Credit Ratings

“…Badanie wpływu zmian cyklu koniunkturalnego przy uwzględnieniu stabilności not ratingowych przeprowadzone zostało przez Altmana i Rijkena (2005). Wpływ koniunktury i dekoniunktury gospodarczej analizowany był dla ratingów kredytowych krajów (Giacomino, 2013;Freitag, 2015), banków (Bangia, Diebold, Schuermann, 1999;Fei Fuertes, Kalotychou, 2012) oraz Patrycja Chodnicka-Jaworska Cykl koniunkturalny zmiany na rynku finansowym -ratingi kredytowe firm (Cesaroni, 2015;Isakin, David, 2015;Iannotta, Nocera, Resti, 2013). Badania wykonywane były głównie dla rynku amerykańskiego (Amato, Furfine, 2003;Auh, 2013).…”

Bank Credit Risk Management and Rating Migration Analysis on the Business Cycle

“…A number of past studies examine the issue of business cycles and states of the economy in the context of credit risk [15,17,18,22,33,38,39,42]. Some approaches classify the states of the economy as finite regimes and assume transition matrices change over time with the states of the economy.…”

“…The dataset contains initially 210,000 observations on 51,000 borrowers, at quarterly intervals [17,58]. Subsequent to a careful data cleansing process, the dataset finally comes down to 185,000 observations on 48,000 firms.…”

“…Credit risk transitions are seen to exhibit different behavioural patterns over different macroeconomic phases and business cycle states (booms-contractions). To take into account the implication of business cycles and real economic activity on credit risk and rating migration behaviour, a number of studies distinguish between different economic phases (regimes), treating booms separately from contractions ( [13][14][15][16][17], inter alia).…”