A nonlinear inversion procedure for modeling the effects of economic factors on credit risk migration

Jeffrey Stokes

Review of Quantitative Finance and Accounting, 2023, vol. 61, issue 3, No 3, 855-878

Abstract: Abstract Ratings migration are most often modeled as a time homogeneous first-order Markov chain. A novel nonlinear inversion procedure is presented for recovering a ratings migration matrix that is indirectly linked to economic factors through a single moment consistency equation. The procedure is comparable to the approach suggested by Belkin et al. (CreditMetrics Monitor 1(2):46–56, 1998) but represents an important nonparametric alternative that may be easier to implement in practice. In addition to having merit for portfolio stress testing, the empirical application of the procedure is demonstrated for the credit quality dynamics portion of CECL methodology.

Keywords: CECL; Credit risk; Ratings migration; Kullback–Leibler divergence; Markov chain; Stress testing; z-score (search for similar items in EconPapers)
JEL-codes: C58 C61 G21 G28 (search for similar items in EconPapers)
Date: 2023
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DOI: 10.1007/s11156-023-01170-3

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