Does Credit Risk Vary with Economic Cycles? The Case of Finland

The significance of credit risk models has increased with the introduction of new Basel accord known as Basel II. The aim of this study is default rate modeling. This paper follows the two possible approaches of a macro credit risk modeling. First, empirical models are investigated. Second, a latent factor model based on Merton's idea is introduced. Both of these models are derived from individual default probability models. We employed data over the time period from 1988 to 2003 of the Finnish economy. First, linear vector autoregressive models were used in the case of dynamic empirical model. We examined how significant macroeconomic indicators determined the default rate in the economy. However these models cannot provide microeconomic foundation as latent factor models. A one-factor model was estimated using disaggregated industrial data. This estimation can help understand relation between credit risk and macroeconomic indicators. Models can be used for default rate prediction or stress testing by central authorities.