Abstract

http://ssrn.com/abstract=314719
 
 

References (64)



 
 

Citations (28)



 


 



The Link between Default and Recovery Rates: Implications for Credit Risk Models and Procyclicality


Andrea Sironi


Bocconi University - Department of Finance

Edward I. Altman


New York University (NYU) - Salomon Center; New York University (NYU) - Department of Finance

Brooks Brady


Standard & Poor's Risk Solutions

Andrea Resti


Bocconi University - Department of Finance

April 2002


Abstract:     
This paper analyzes the impact of various assumptions about the association between aggregate default probabilities and the loss given default on bank loans and corporate bonds, and seeks to empirically explain this critical relationship. Moreover, it simulates the effects on mandatory capital requirements like those proposed in 2001 by the Basel Committee on Banking Supervision. We present the analysis and results in four distinct sections. The first section examines the literature of the last three decades of the various structural-form, closed-form and other credit risk and portfolio credit value-at-risk (VaR) models and the way they explicitly or implicitly treat the recovery rate variable. Section 2 presents simulation results under three different recovery rate scenarios and examines the impact of these scenarios on the resulting risk measures: our results show a significant increase in both expected and unexpected losses when recovery rates are stochastic and negatively correlated with default probabilities. In Section 3, we empirically examine the recovery rates on corporate bond defaults, over the period 1982-2000. We attempt to explain recovery rates by specifying a rather straightforward statistical least squares regression model. The central thesis is that aggregate recovery rates are basically a function of supply and demand for the securities. Our econometric univariate and multivariate time series models explain a significant portion of the variance in bond recovery rates aggregated across all seniority and collateral levels. Finally, in Section 4 we analyze how the link between default probability and recovery risk would affect the procyclicality effects of the New Basel Capital Accord, due to be released in 2002. We see that, if banks use their own estimates of LGD (as in the "advanced" IRB approach), an increase in the sensitivity of banks' LGD due to the variation in PD over economic cycles is likely to follow. Our results have important implications for just about all portfolio credit risk models, for markets which depend on recovery rates as a key variable (e.g., securitizations, credit derivatives, etc.), for the current debate on the revised BIS guidelines for capital requirements on bank credit assets, and for investors in corporate bonds of all credit qualities.

Number of Pages in PDF File: 44

Keywords: credit rating, capital requirements, credit risk, recovery rate, default, procyclicality

JEL Classification: G15, G21, G28

working papers series





Download This Paper

Date posted: June 22, 2002  

Suggested Citation

Sironi, Andrea and Altman, Edward I. and Brady, Brooks and Resti, Andrea, The Link between Default and Recovery Rates: Implications for Credit Risk Models and Procyclicality (April 2002). Available at SSRN: http://ssrn.com/abstract=314719 or http://dx.doi.org/10.2139/ssrn.314719

Contact Information

Andrea Sironi (Contact Author)
Bocconi University - Department of Finance ( email )
Via Roentgen 1
Milano, MI 20136
Italy
Edward I. Altman
New York University (NYU) - Salomon Center ( email )
44 West 4th Street
New York, NY 10012
United States
212-998-0709 (Phone)
212-995-4220 (Fax)
New York University (NYU) - Department of Finance ( email )
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
Brooks Brady
Standard & Poor's Risk Solutions ( email )
55 Water Street
New York, NY 10041
United States
Andrea Resti
Bocconi University - Department of Finance ( email )
Via Roentgen 1
Milano, MI 20136
Italy
Feedback to SSRN


Paper statistics
Abstract Views: 9,597
Downloads: 3,245
Download Rank: 1,208
References:  64
Citations:  28

© 2014 Social Science Electronic Publishing, Inc. All Rights Reserved.  FAQ   Terms of Use   Privacy Policy   Copyright   Contact Us
This page was processed by apollo4 in 0.391 seconds