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

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Author Info

  • Siem Jan Koopman

    ()
    (Faculty of Economics and Business Administration, Vrije Universiteit Amsterdam)

  • André Lucas

    ()
    (Faculty of Economics and Business Administration, Vrije Universiteit Amsterdam)

  • Pieter Klaassen

    ()
    (ABNAMRO Bank NV, and Vrije Universiteit Amsterdam)

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 behavior in default rates. The cycle has a period of around 10 years. We also detect longer term movements in default probabilities and default correlations. Our findings have important implications for portfolio credit risk analysis. First, a static analysis of portfolio credit risk can underestimate credit risk significantly by not accounting for the dynamic and cyclical behaviour of default probabilities. Second, estimating default correlations over long horizons without accounting for time variation may lead to misspecified risk management models. We highlight the main effects in an actual credit risk experiment, addressing the issue of pro-cyclicality in ratings and capital buffer formation. It turns out that dynamic models anticipate much better on required capital buffer increases than rating strategies based on recent historical data. In this way, dynamic credit risk models may help to alleviate part of the pro-cyclicality problem.

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Bibliographic Info

Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 02-107/2.

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Date of creation: 24 Oct 2002
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Handle: RePEc:dgr:uvatin:20020107

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Web page: http://www.tinbergen.nl

Related research

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

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References

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  1. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March.
  2. Siem Jan Koopman & Neil Shephard & Jurgen A. Doornik, 1999. "Statistical algorithms for models in state space using SsfPack 2.2," Econometrics Journal, Royal Economic Society, vol. 2(1), pages 107-160.
  3. Jarrow, Robert A & Lando, David & Turnbull, Stuart M, 1997. "A Markov Model for the Term Structure of Credit Risk Spreads," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 481-523.
  4. Bangia, Anil & Diebold, Francis X. & Kronimus, Andre & Schagen, Christian & Schuermann, Til, 2002. "Ratings migration and the business cycle, with application to credit portfolio stress testing," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 445-474, March.
  5. Lucas, Andre & Klaassen, Pieter & Spreij, Peter & Straetmans, Stefan, 2001. "An analytic approach to credit risk of large corporate bond and loan portfolios," Journal of Banking & Finance, Elsevier, vol. 25(9), pages 1635-1664, September.
  6. Durbin, James & Koopman, Siem Jan, 2001. "Time Series Analysis by State Space Methods," OUP Catalogue, Oxford University Press, number 9780198523543, September.
  7. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  8. Harvey, A C & Jaeger, A, 1993. "Detrending, Stylized Facts and the Business Cycle," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 8(3), pages 231-47, July-Sept.
  9. Laeven, Luc & Majnoni, Giovanni, 2001. "Loan loss provisioning and economic slowdowns : too much, too late?," Policy Research Working Paper Series 2749, The World Bank.
  10. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
  11. Vogelsang, Timothy J., 1997. "Wald-Type Tests for Detecting Breaks in the Trend Function of a Dynamic Time Series," Econometric Theory, Cambridge University Press, vol. 13(06), pages 818-848, December.
  12. repec:cup:etheor:v:13:y:1997:i:6:p:818-49 is not listed on IDEAS
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Cited by:
  1. André Lucas & Pieter Klaassen, 2003. "Discrete versus Continuous State Switching Models for Portfolio Credit Risk," Tinbergen Institute Discussion Papers 03-075/2, Tinbergen Institute, revised 30 Sep 2003.
  2. Ji, Tingting, 2004. "Essays on consumer portfolio choice and credit risk," MPRA Paper 3161, University Library of Munich, Germany.
  3. Pederzoli, Chiara & Torricelli, Costanza, 2005. "Capital requirements and business cycle regimes: Forward-looking modelling of default probabilities," Journal of Banking & Finance, Elsevier, vol. 29(12), pages 3121-3140, December.
  4. André Lucas & Pieter Klaassen, 2003. "Discrete versus Continuous State Switching Models for Portfolio Credit Risk," Tinbergen Institute Discussion Papers 03-075/2, Tinbergen Institute, revised 30 Sep 2003.

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