Cyclical default and recovery in stress testing loan losses
AbstractWe present a macro variable-based empirical model for corporate bank loans’ credit risk. The model captures the well-known positive relationship between probability of default (PD) and loss given default (LGD; i.e., the inverse of recovery) and their counter-cyclical movement with the business cycle. In the absence of proper micro data on LGD, we use a random-sampling method to estimate the annual average LGD. We specify a two equation model for PD and LGD which is estimated with Finnish time-series data from 1989 to 2008. We also use a system of time-series models for the exogenous macro variables to derive the main macroeconomic shocks which are then used in stress testing aggregate loan losses. We show that the endogenous LGD makes a considerable difference in stress tests compared to a constant LGD assumption.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Financial Stability.
Volume (Year): 9 (2013)
Issue (Month): 1 ()
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Web page: http://www.elsevier.com/locate/jfstabil
PD; LGD; Credit risk; Bank loans; Macroprudential analysis; Stress testing;
Find related papers by JEL classification:
- G01 - Financial Economics - - General - - - Financial Crises
- G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
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