Cyclical default and recovery in stress testing loan losses

Esa Jokivuolle () and Matti Virén

Journal of Financial Stability, 2013, vol. 9, issue 1, 139-149

Abstract: We present a macro variable-based empirical model for corporate bank loans’ credit risk. The model captures the well-known positive relationship between probability of default (PD) and loss given default (LGD; i.e., the inverse of recovery) and their counter-cyclical movement with the business cycle. In the absence of proper micro data on LGD, we use a random-sampling method to estimate the annual average LGD. We specify a two equation model for PD and LGD which is estimated with Finnish time-series data from 1989 to 2008. We also use a system of time-series models for the exogenous macro variables to derive the main macroeconomic shocks which are then used in stress testing aggregate loan losses. We show that the endogenous LGD makes a considerable difference in stress tests compared to a constant LGD assumption.

Keywords: PD; LGD; Credit risk; Bank loans; Macroprudential analysis; Stress testing (search for similar items in EconPapers)
JEL-codes: G01 G17 G21 G32 (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (15)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:9:y:2013:i:1:p:139-149

DOI: 10.1016/j.jfs.2011.10.001

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