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The Link Between Default and Recovery Rates: Effets on the Procyclicality of Regulatory Capital Rati
Year Of Publication: 2002
Month Of Publication: July
Pages: 37
Download Count: 877
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Comment Num: 0
Language: EN
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Who Can Read: Free
Date: 7-29-2004
Publisher: Administrator
Summary
This paper analyses the impact of various assumptions about the association between aggregatedefault probabilities and the loss given default on bank loans and corporate bonds, and seeks toempirically explain this critical relationship. Moreover, it simulates the effects of this relationship on theprocyclicality of mandatory capital requirements like those proposed in 2001 by the Basel Committeeon Banking Supervision. We present the analysis and results in four distinct sections. The first sectionexamines the literature of the last three decades of the various structural-form, closed-form and othercredit risk and portfolio credit value-at-risk (VaR) models and the way they explicitly or implicitly treatthe recovery rate variable. Section 2 presents simulation results under three different recovery ratescenarios and examines the impact of these scenarios on the resulting risk measures: our resultsshow a significant increase in both expected an unexpected losses when recovery rates are stochasticand negatively correlated with default probabilities. In Section 3, we empirically examine the recoveryrates on corporate bond defaults, over the period 1982-2000. We attempt to explain recovery rates byspecifying a rather straightforward statistical least squares regression model. The central thesis is thataggregate recovery rates are basically a function of supply and demand for the securities. Oureconometric univariate and multivariate time series models explain a significant portion of the variancein bond recovery rates aggregated across all seniority and collateral levels. Finally, in Section 4 weanalyse how the link between default probability and recovery risk would affect the procyclicalityeffects of the New Basel Capital Accord, due to be released in 2002. We see that, if banks are let freeto use their own estimates of LGD (as in the “advanced” IRB approach), an increase in their sensitivityto economic cycles would follow. Our results have important implications for just about all portfoliocredit risk models, for markets which depend on recovery rates as a key variable (eg securitisations,credit derivatives, etc), for the current debate on the revised BIS guidelines for capital requirements onbank credit assets, and for investors in corporate bonds of all credit qualitie
Author(s)
Altman, Edward I. Sign in to follow this author
Resti, Andrea Sign in to follow this author
Sironi, Andrea Sign in to follow this author
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