The recent global financial crisis has served as a stark reminder of the
crucial role of systematic stress testing of financial institutions'
portfolios, particularly, their lending books. In response to the regulatory
deficiencies thus revealed, Basel III is seeking to achieve the broader
macroprudential goal of protecting the banking sector from periods of excess
credit growth by requesting longer horizon default probabilities, downturn
loss-given-default measures and improved calibration of risk models.
The calibration of models that translate credit ratings and/or market data into
default probabilities has direct implications for the determination of the
risk-adjusted capital that banks need to hold to back their loans and safeguard
A Mixture of Markov Chains (MMC) approach is proposed to estimate credit
rating migration risk that controls for the business-cycle evolution during the
relevant time horizon in order to ensure adequate capital buffers both in good
and bad times. The approach allows the default risk associated with a given
credit rating to change as the economy moves through different points in the
The findings suggest that ignoring business cycles significantly understates
default risk during economic contraction. The MMC approach yields more reliable
default risk measures than a naïve unconditional cyclical estimator, especially
in contraction. The MMC approach is more efficient and provides superior
out-of-sample credit rating migration risk predictions at long horizons the
An application to economic capital attribution suggests that the buffers
prescribed by the MMC and naïve cyclical approaches are higher than those from
classical through-the-cycle estimators, particularly in economic contraction.
However, default risk during contraction (expansion) is statistically and
economically overestimated (underestimated) by the naïve cyclical approach
relative to the MMC approach and more so for longer prediction horizons.
Banks using the MMC estimator would counter-cyclically increase capital by 6%
during economic expansion and free up to 17% capital for lending during
downturns relative to the naïve estimator. The excess cyclicality in capital
requirements associated to the naïve model would make lending very costly for
banks in troubled times imposing too great a cost on economic growth and
potentially aggravating a contraction.
This analysis has important implications for the ongoing financial regulatory
reforms. The properties of the MMC estimator here documented are well aligned
with the Basel III macroprudential initiative to dampen procyclicality by
reducing the recession-versus-expansion gap in capital buffers and to
lengthening the credit risk horizon.