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Credit Rating Migration Risk and Business Cycles
Author(s) -
Fei Fei,
Fuertes AnaMaria,
Kalotychou Elena
Publication year - 2012
Publication title -
journal of business finance and accounting
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.282
H-Index - 77
eISSN - 1468-5957
pISSN - 0306-686X
DOI - 10.1111/j.1468-5957.2011.02272.x
Subject(s) - business cycle , basel ii , recession , credit risk , capital requirement , credit rating , basel iii , estimator , economics , capital adequacy ratio , capital (architecture) , probability of default , risk adjusted return on capital , monetary economics , business , financial system , finance , financial capital , human capital , macroeconomics , microeconomics , mathematics , capital formation , statistics , profit (economics) , history , archaeology , incentive , economic growth
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.