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Dependent default and recovery: MCMC study of downturn LGD credit risk model

  • Pavel V. Shevchenko
  • Xiaolin Luo
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    There is empirical evidence that recovery rates tend to go down just when the number of defaults goes up in economic downturns. This has to be taken into account in estimation of the capital against credit risk required by Basel II to cover losses during the adverse economic downturns; the so-called "downturn LGD" requirement. This paper presents estimation of the LGD credit risk model with default and recovery dependent via the latent systematic risk factor using Bayesian inference approach and Markov chain Monte Carlo method. This approach allows joint estimation of all model parameters and latent systematic factor, and all relevant uncertainties. Results using Moody's annual default and recovery rates for corporate bonds for the period 1982-2010 show that the impact of parameter uncertainty on economic capital can be very significant and should be assessed by practitioners.

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    File URL: http://arxiv.org/pdf/1112.5766
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    Paper provided by arXiv.org in its series Papers with number 1112.5766.

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    Date of creation: Dec 2011
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    Publication status: Published in ANZIAM Journal 53, pp. C185-C202, 2012
    Handle: RePEc:arx:papers:1112.5766
    Contact details of provider: Web page: http://arxiv.org/

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    1. 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.).
    2. Jon Frye, 2000. "Depressing recoveries," Emerging Issues, Federal Reserve Bank of Chicago, issue Oct.
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