Credit rating migration risk and business cycles

Fei, F., Fuertes, A.M. and Kalotychou, E. 2012. Credit rating migration risk and business cycles. Journal of Business Finance & Accounting. 39 (1&2), pp. 229-263.

TitleCredit rating migration risk and business cycles
AuthorsFei, F., Fuertes, A.M. and Kalotychou, E.

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 na¨ıve 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 na¨ıve 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.

JournalJournal of Business Finance & Accounting
Journal citation39 (1&2), pp. 229-263
YearJan 2012
Digital Object Identifier (DOI)
Publication dates
PublishedJan 2012

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