Credit Rating Migration Risk and Business Cycles

35 Pages Posted: 3 Mar 2012

See all articles by Fei Fei

Fei Fei

Barclays

Ana-Maria Fuertes

Cass Business School, City University of London

Elena Kalotychou

Cass Business School, City, University of London

Date Written: January/February 2012

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

Suggested Citation

Fei, Fei and Fuertes, Ana-Maria and Kalotychou, Elena, Credit Rating Migration Risk and Business Cycles (January/February 2012). Journal of Business Finance & Accounting, Vol. 39, Issue 1‐2, pp. 229-263, 2012, Available at SSRN: https://ssrn.com/abstract=2015149 or http://dx.doi.org/10.1111/j.1468-5957.2011.02272.x

Fei Fei

Barclays

1 Churchill Place
London, E14 5HP
United Kingdom

Ana-Maria Fuertes

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

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