The credit rating process and estimation of transition probabilities: A Bayesian approach
The Basel II Accord requires banks to establish rigorous statistical procedures for the estimation and validation of default and ratings transition probabilities. This raises great technical challenges when sufficient default data are not available, as is the case for low default portfolios. We develop a new model that describes the typical internal credit rating process used by banks. The model captures patterns of obligor heterogeneity and ratings migration dependence through unobserved systematic macroeconomic shocks. We describe a Bayesian hierarchical framework for model calibration from historical rating transition data, and show how the predictive performance of the model can be assessed, even with sparse event data. Finally, we analyze a rating transition data set from Standard and Poor's during 1981-2007. Our results have implications for the current Basel II policy debate on the magnitude of default probabilities assigned to low risk assets.
If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- David J. Spiegelhalter & Nicola G. Best & Bradley P. Carlin & Angelika van der Linde, 2002. "Bayesian measures of model complexity and fit," Journal of the Royal Statistical Society Series B, Royal Statistical Society, vol. 64(4), pages 583-639.
- Christensen, Jens H.E. & Hansen, Ernst & Lando, David, 2004. "Confidence sets for continuous-time rating transition probabilities," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2575-2602, November.
- Lando, David & Skodeberg, Torben M., 2002. "Analyzing rating transitions and rating drift with continuous observations," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 423-444, March.
- McNeil, Alexander J. & Wendin, Jonathan P., 2007. "Bayesian inference for generalized linear mixed models of portfolio credit risk," Journal of Empirical Finance, Elsevier, vol. 14(2), pages 131-149, March.
- Patrick Gagliardini, 2005.
"Stochastic Migration Models with Application to Corporate Risk,"
Journal of Financial Econometrics,
Society for Financial Econometrics, vol. 3(2), pages 188-226.
- Patrick Gagliardini & Christian Gourieroux, 2004. "Stochastic Migration Models with Application to Corporate Risk," Working Papers 2004-35, Centre de Recherche en Economie et Statistique.
- Hanson, Samuel G. & Pesaran, M. Hashem & Schuermann, Til, 2008.
"Firm heterogeneity and credit risk diversification,"
Journal of Empirical Finance,
Elsevier, vol. 15(4), pages 583-612, September.
- Samuel Hanson & M. Hashem Pesaran & Til Schuermann, 2005. "Firm Heterogeneity and Credit Risk Diversification," CESifo Working Paper Series 1531, CESifo Group Munich.
- Altman, Edward I. & Rijken, Herbert A., 2004. "How rating agencies achieve rating stability," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2679-2714, November.
- Pamela Nickell & William Perraudin & Simone Varotto, 2001.
"Stability of ratings transitions,"
Bank of England working papers
133, Bank of England.
- Hanson, Samuel & Schuermann, Til, 2006. "Confidence intervals for probabilities of default," Journal of Banking & Finance, Elsevier, vol. 30(8), pages 2281-2301, August.
- Frydman, Halina & Schuermann, Til, 2008. "Credit rating dynamics and Markov mixture models," Journal of Banking & Finance, Elsevier, vol. 32(6), pages 1062-1075, June.
- Farnsworth, Heber & Li, Tao, 2007. "The Dynamics of Credit Spreads and Ratings Migrations," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(03), pages 595-620, September.
- 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.
- Anil Bangia & Francis X. Diebold & Til Schuermann, 2000. "Ratings Migration and the Business Cycle, With Application to Credit Portfolio Stress Testing," Center for Financial Institutions Working Papers 00-26, Wharton School Center for Financial Institutions, University of Pennsylvania.
- Carey, Mark & Hrycay, Mark, 2001. "Parameterizing credit risk models with rating data," Journal of Banking & Finance, Elsevier, vol. 25(1), pages 197-270, January.
- Jafry, Yusuf & Schuermann, Til, 2004. "Measurement, estimation and comparison of credit migration matrices," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2603-2639, November.
- Michael B. Gordy, 2002.
"A risk-factor model foundation for ratings-based bank capital rules,"
Finance and Economics Discussion Series
2002-55, Board of Governors of the Federal Reserve System (U.S.).
- Gordy, Michael B., 2003. "A risk-factor model foundation for ratings-based bank capital rules," Journal of Financial Intermediation, Elsevier, vol. 12(3), pages 199-232, July.
- Shumway, Tyler, 2001. "Forecasting Bankruptcy More Accurately: A Simple Hazard Model," The Journal of Business, University of Chicago Press, vol. 74(1), pages 101-24, January.
When requesting a correction, please mention this item's handle: RePEc:eee:empfin:v:16:y:2009:i:2:p:216-234. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.