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.
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.