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Pro-Cyclicality, Empirical Credit Cycles, and Capital Buffer Formation

Author

Listed:
  • Siem Jan Koopman

    (Faculty of Economics and Business Administration, Vrije Universiteit Amsterdam)

  • André Lucas

    (Faculty of Economics and Business Administration, Vrije Universiteit Amsterdam)

  • Pieter Klaassen

    (ABNAMRO Bank NV, and Vrije Universiteit Amsterdam)

Abstract

We model 1927-1997 U.S. business failure rates using a time series approach based on unobserved components. Clear evidence is found of cyclical behavior in default rates. The cycle has a period of around 10 years. We also detect longer term movements in default probabilities and default correlations. Our findings have important implications for portfolio credit risk analysis. First, a static analysis of portfolio credit risk can underestimate credit risk significantly by not accounting for the dynamic and cyclical behaviour of default probabilities. Second, estimating default correlations over long horizons without accounting for time variation may lead to misspecified risk management models. We highlight the main effects in an actual credit risk experiment, addressing the issue of pro-cyclicality in ratings and capital buffer formation. It turns out that dynamic models anticipate much better on required capital buffer increases than rating strategies based on recent historical data. In this way, dynamic credit risk models may help to alleviate part of the pro-cyclicality problem.

Suggested Citation

  • Siem Jan Koopman & André Lucas & Pieter Klaassen, 2002. "Pro-Cyclicality, Empirical Credit Cycles, and Capital Buffer Formation," Tinbergen Institute Discussion Papers 02-107/2, Tinbergen Institute.
  • Handle: RePEc:tin:wpaper:20020107
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    References listed on IDEAS

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    Cited by:

    1. Ji, Tingting, 2004. "Consumer Credit Delinquency And Bankruptcy Forecasting Using Advanced Econometrc Modeling," MPRA Paper 3187, University Library of Munich, Germany.
    2. Lucas, Andre & Klaassen, Pieter, 2006. "Discrete versus continuous state switching models for portfolio credit risk," Journal of Banking & Finance, Elsevier, vol. 30(1), pages 23-35, January.

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    More about this item

    Keywords

    credit risk; pro-cyclicality; capital requirements; dynamic models; common factors; credit cycles; time varying parameters;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • C19 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Other

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