|Title||Credit rating migration risk and business cycles|
|Authors||Fei, 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.
|Journal||Journal of Business Finance & Accounting|
|Journal citation||39 (1&2), pp. 229-263|
|Digital Object Identifier (DOI)||https://doi.org/10.1111/j.1468-5957.2011.02272.x|