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A nonlinear inversion procedure for modeling the effects of economic factors on credit risk migration

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  • Jeffrey R. Stokes

    (University of Nebraska-Lincoln)

Abstract

Ratings migration are most often modeled as a time homogeneous first-order Markov chain. A novel nonlinear inversion procedure is presented for recovering a ratings migration matrix that is indirectly linked to economic factors through a single moment consistency equation. The procedure is comparable to the approach suggested by Belkin et al. (CreditMetrics Monitor 1(2):46–56, 1998) but represents an important nonparametric alternative that may be easier to implement in practice. In addition to having merit for portfolio stress testing, the empirical application of the procedure is demonstrated for the credit quality dynamics portion of CECL methodology.

Suggested Citation

  • Jeffrey R. Stokes, 2023. "A nonlinear inversion procedure for modeling the effects of economic factors on credit risk migration," Review of Quantitative Finance and Accounting, Springer, vol. 61(3), pages 855-878, October.
    • Handle: RePEc:kap:rqfnac:v:61:y:2023:i:3:d:10.1007_s11156-023-01170-3
    DOI: 10.1007/s11156-023-01170-3
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    More about this item

    Keywords

    CECL; Credit risk; Ratings migration; Kullback–Leibler divergence; Markov chain; Stress testing; z-score;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • 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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