Cyclicality in Losses on Bank Loans
Tinbergen Institute Discussion Paper 15-050/III
68 Pages Posted: 5 May 2015 Last revised: 7 Oct 2017
Date Written: September 1, 2017
Based on unique data we show that macro variables, the default rate and loss given default of bank loans share common cyclical components. The innovation in our model is the distinction between loans with either severe or mild losses. The variation in the proportion of these two types drives the cyclic behavior of the loss given default, and constitutes the links with the default rate and macro variables. These links vary according to loan and borrower characteristics. During downturns, the proportion of defaults with severe losses increases, but the distribution of losses conditional on their being mild or severe does not change. Though loans are monitored more closely than bonds and are more senior, the cyclical variation in their losses resembles those for bonds, albeit around a lower average level. This variation leads to an increase in the capital reserves required for loan portfolios.
Keywords: Loss-given-default, default rates, credit risk, capital requirements, dynamic factor models
JEL Classification: C32, C58, G21, G33
Suggested Citation: Suggested Citation