Credit Rating Migration Risk and Business Cycles
Journal of Business Finance & Accounting 39, 229-263
42 Pages Posted: 2 Dec 2011 Last revised: 19 Dec 2013
Date Written: December 2, 2011
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.
Keywords: Basel III, Credit risk, Default probability, Out-of-sample prediction, Procyclicality, Rating migration, Value-at-Risk
JEL Classification: C13, C41, G21, G28
Suggested Citation: Suggested Citation