Pro-Cyclicality, Empirical Credit Cycles, and Capital Buffer Formation

31 Pages Posted: 27 Jul 2003

See all articles by Siem Jan Koopman

Siem Jan Koopman

Vrije Universiteit Amsterdam - School of Business and Economics; Tinbergen Institute; Aarhus University - CREATES

Andre Lucas

Vrije Universiteit Amsterdam - School of Business and Economics; Tinbergen Institute

Pieter Klaassen

UBS AG

Date Written: January 3, 2003

Abstract

We model 1927-1997 U.S. business failure rates using a time series approach based on unobserved components. Clear evidence is found of cyclical behaviour in default rates. The cycle has a period of around 10 years. We also detect longer term movements in default rates and default correlations. In a credit risk experiment we show that accommodation of these default rate dynamics has important consequences for capitalisation requirements for credit risk. First, the static variants of credit risk portfolio models that are typically used by financial institutions and their regulators may significantly underestimate capital requirements for credit risk. Second, models that account for the observed dynamic behaviour of default rates do anticipate on required increases in capital, in contrast to models that only use recent historical default rate data. Hence, dynamic credit risk models may help to alleviate the problems of pro-cyclicality in capital requirements. Besides, we show that the size of the net margin is an important determinant of the level of capital needed. Ignoring the net margin in dynamic credit risk analyses may lead to overly conservative capital requirements.

Note: Previously titled "Multi-Stage Capital Requirements and the Impact of Empirical Credit Cycles"

Keywords: credit risk, pro-cyclicality, capital requirements, dynamic models, common factors, credit cycles, time varying parameters

JEL Classification: G21, C19

Suggested Citation

Koopman, Siem Jan and Lucas, Andre and Klaassen, Pieter, Pro-Cyclicality, Empirical Credit Cycles, and Capital Buffer Formation (January 3, 2003). EFA 2003 Annual Conference Paper No. 211; Vrije University Finance Working Paper, Available at SSRN: https://ssrn.com/abstract=302688 or http://dx.doi.org/10.2139/ssrn.302688

Siem Jan Koopman (Contact Author)

Vrije Universiteit Amsterdam - School of Business and Economics ( email )

De Boelelaan 1105
Amsterdam, 1081 HV
Netherlands
+31205986019 (Phone)

HOME PAGE: http://sjkoopman.net

Tinbergen Institute ( email )

Gustav Mahlerplein 117
1082 MS Amsterdam
Netherlands

HOME PAGE: http://personal.vu.nl/s.j.koopman

Aarhus University - CREATES ( email )

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Andre Lucas

Vrije Universiteit Amsterdam - School of Business and Economics ( email )

De Boelelaan 1105
Amsterdam, 1081 HV
Netherlands
+31 20 598 6039 (Phone)
+31 20 598 6020 (Fax)

HOME PAGE: http://personal.vu.nl/a.lucas

Tinbergen Institute

Roetersstraat 31
Amsterdam, 1018 WB
Netherlands

HOME PAGE: http://www.tinbergen.nl

Pieter Klaassen

UBS AG ( email )

Postfach
Zurich, 8076
Switzerland

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