Ratings Migration and the Business Cycle, With Application to Credit Portfolio Stress Testing

46 Pages Posted: 2 May 2001  

Anil Bangia

Oliver, Wyman & Company, LLC.

Francis X. Diebold

University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER)

Til Schuermann

Oliver Wyman

Date Written: April 11, 2000

Abstract

The turmoil in the capital markets in 1997 and 1998 has highlighted the need for systematic stress testing of banks' portfolios, including both their trading and lending books. We propose that underlying macroeconomic volatility is a key part of a useful conceptual framework for stress testing credit portfolios, and that credit migration matrices provide the specific linkages between underlying macroeconomic conditions and asset quality. Credit migration matrices, which characterize the expected changes in credit quality of obligors, are cardinal inputs to many applications, including portfolio risk assessment, modeling the term structure of credit risk premia, and pricing of credit derivatives. They are also an integral part of many of the credit portfolio models used by financial institutions. By separating the economy into two states or regimes, expansion and contraction, and conditioning the migration matrix on these states, we show that the loss distribution of credit portfolios can differ greatly, as can the concomitant level of economic capital to be assigned.

Keywords: Credit risk, stress testing, ratings migration, credit portfolio management

JEL Classification: G11, G21, G28

Suggested Citation

Bangia, Anil and Diebold, Francis X. and Schuermann, Til, Ratings Migration and the Business Cycle, With Application to Credit Portfolio Stress Testing (April 11, 2000). PIER Working Paper No. 01-004. Available at SSRN: https://ssrn.com/abstract=231152 or http://dx.doi.org/10.2139/ssrn.231152

Anil Bangia

Oliver, Wyman & Company, LLC.

666 Fifth Ave.
New York, NY 10103
United States

Francis X. Diebold (Contact Author)

University of Pennsylvania - Department of Economics ( email )

160 McNeil Building
3718 Locust Walk
Philadelphia, PA 19104
United States
215-898-1507 (Phone)
215-573-4217 (Fax)

HOME PAGE: http://www.ssc.upenn.edu/~fdiebold/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Til Schuermann

Oliver Wyman ( email )

1166 6th Avenue
New York City, NY
United States

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