A novel factor model to determine recovery rates of bank credit towards local governments

The 2008 international financial crisis showed an increase in the probability of loan default was followed by a fall in recovery rates. This fact has been investigated in corporate loans and bonds but not with respect to Local Government (LG) loans, due to the lack of databases with historical information on recovery rates. In the present study we address this question, using a factor model of credit risk based on the Basel Banking Regulation (BBR), with a data panel derived from 1,160 LGs for the period 2009–2014. The historical value for recovery rates is obtained from the loss given default floor reduced by collaterals, and the relationship between default and recovery rates is obtained by the conditional probability of default (CPD). Our findings reveal the effect on the credit recovery rate of variables such as tax revenues, sovereign risk premium, regulatory quality and CPD. The main conclusion reached is that the probability of default (PD) increases when own income, tax revenues, treasury balances and rights collection fall, and when per capita debt rises. The model is innovative and useful for Local Governments, financial institutions, policymakers, and researchers to understand and prevent the financial crisis’s effects on local credit risk.