Ratings Migration and the Business Cycle, With Application to Credit Portfolio Stress Testing
AbstractThe 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.
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Bibliographic InfoPaper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 00-26.
Date of creation: Apr 2000
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Credit risk; stress testing; ratings migration; credit portfolio management;
Other versions of this item:
- 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.
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
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