|
Archive@NYU >
Stern School of Business >
Finance Working Papers >
Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26493
|
| Title: | The Link between Default and Recovery Rates: Implications for Credit
Risk Models and Procyclicality |
| Authors: | Altman, Edward I.
Brady, Brooks
Resti, Andrea
Sironi, Andrea |
| Keywords: | credit rating
capital requirements
credit risk
recovery rate
default
procyclicality |
| Issue Date: | Jul-2002 |
| Series/Report no.: | FIN-02-049 |
| Abstract: | This paper analyzes the impact of various assumptions about the
association between aggregate default probabilities and the loss given
default on bank loans and corporate bonds, and seeks to empirically
explain this critical relationship. Moreover, it simulates the effects
on mandatory capital requirements like those proposed in 2001 by the
Basel Committee on Banking Supervision. We present the analysis and
results in four distinct sections. The first section examines the
literature of the last three decades of the various structural-form,
closed-form and other credit risk and portfolio credit value-at-risk
(VaR) models and the way they explicitly or implicitly treat the
recovery rate variable. Section 2 presents simulation results under
three different recovery rate scenarios and examines the impact of these
scenarios on the resulting risk measures: our results show a significant
increase in both expected and unexpected losses when recovery rates are
stochastic and negatively correlated with default probabilities. In
Section 3, we empirically examine the recovery rates on corporate bond
defaults, over the period 1982-2000. We attempt to explain recovery
rates by specifying a rather straightforward statistical least squares
regression model. The central thesis is that aggregate recovery rates
are basically a function of supply and demand for the securities. Our
econometric univariate and multivariate time series models explain a
significant portion 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 the procyclicality effects of the New Basel Capital Accord, due
to be released in 2002. We see that, if banks use their own estimates of
LGD (as in the “advanced” IRB approach), an increase in the
sensitivity of banks’ LGD due to the variation in PD over economic
cycles is likely to follow. Our results have important implications for
just about all portfolio credit risk models, for markets which depend on
recovery rates as a key variable (e.g., securitizations, credit
derivatives, etc.), for the current debate on the revised BIS guidelines
for capital requirements on bank credit assets, and for investors in
corporate bonds of all credit qualities. |
| URI: | http://hdl.handle.net/2451/26493 |
| Appears in Collections: | Finance Working Papers
|
All items in Faculty Digital Archive are protected by copyright, with all rights reserved.
|
