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The Link Between Default and Recovery Rates: Implications for Credit Risk Models and Procyclicality
Year Of Publication: 2002
Month Of Publication: April
Pages: 46
Download Count: 874
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Comment Num: 0
Language: EN
Who Can Read: Free
Date: 7-29-2004
Publisher: Administrator
AbstractThis paper analyzes the impact of various assumptions about the association between aggregate defaultprobabilities and the loss given default on bank loans and corporate bonds, and seeks to empiricallyexplain this critical relationship. Moreover, it simulates the effects on mandatory capital requirements likethose proposed in 2001 by the Basel Committee on Banking Supervision. We present the analysis andresults in four distinct sections. The first section examines the literature of the last three decades of thevarious structural-form, closed-form and other credit risk and portfolio credit value-at-risk (VaR) modelsand the way they explicitly or implicitly treat the recovery rate variable. Section 2 presents simulationresults under three different recovery rate scenarios and examines the impact of these scenarios on theresulting risk measures: our results show a significant increase in both expected and unexpected losseswhen recovery rates are stochastic and negatively correlated with default probabilities. In Section 3, weempirically examine the recovery rates on corporate bond defaults, over the period 1982-2000. Weattempt to explain recovery rates by specifying a rather straightforward statistical least squares regressionmodel. The central thesis is that aggregate recovery rates are basically a function of supply and demandfor the securities. Our econometric univariate and multivariate time series models explain a significantportion of the variance in bond recovery rates aggregated across all seniority and collateral levels. Finally,in Section 4 we analyze how the link between default probability and recovery risk would affect theprocyclicality effects of the New Basel Capital Accord, due to be released in 2002. We see that, if banksuse their own estimates of LGD (as in the “advanced” IRB approach), an increase in the sensitivity ofbanks’ LGD due to the variation in PD over economic cycles is likely to follow. Our results haveimportant implications for just about all portfolio credit risk models, for markets which depend onrecovery rates as a key variable (e.g., securitizations, credit derivatives, etc.), for the current debate on therevised BIS guidelines for capital requirements on bank credit assets, and for investors in corporate bondsof all credit qualiti
Altman, Edward I. Sign in to follow this author
Brady, Brooks 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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