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

See all articles by Ana-Maria Fuertes

Ana-Maria Fuertes

Cass Business School, City University of London

Elena Kalotychou

Cass Business School, City, University of London

Fei Fei

Barclays

Date Written: December 2, 2011

Abstract

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

Fuertes, Ana-Maria and Kalotychou, Elena and Fei, Fei, Credit Rating Migration Risk and Business Cycles (December 2, 2011). Journal of Business Finance & Accounting 39, 229-263 , Available at SSRN: https://ssrn.com/abstract=1967403

Ana-Maria Fuertes (Contact Author)

Cass Business School, City University of London ( email )

Faculty of Finance
106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 207 477 0186 (Phone)
+44 207 477 8881 (Fax)

HOME PAGE: http://www.city.ac.uk/people/academics/ana-maria-fuertes

Elena Kalotychou

Cass Business School, City, University of London ( email )

106 Bunhill Row
London, EC1Y 8TZ
Great Britain

Fei Fei

Barclays

1 Churchill Place
London, E14 5HP
United Kingdom

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