Credit Transition and Structural Shocks

Camilla Ferretti, Giampaolo Gabbi, Piero Ganugi () and Pietro Vozzella ()
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Giampaolo Gabbi: SDA Bocconi School of Management, Milano 20136, Italy
Piero Ganugi: Department of Industrial Engineering, University of Parma, Parma 43100, Italy
Pietro Vozzella: Department of Management and Law, University of Siena, Siena 53100, Italy

Quarterly Journal of Finance (QJF), 2022, vol. 12, issue 01, 1-28

Abstract: Credit risk involves not only the complexity of screening but also monitoring and estimating rating transition. The adoption of inadequate transition matrices causes a misevaluation of credit risk, a consequent misallocation of capital, with the prospect that the lending process will be affected by increasing transaction costs and limited rationality, especially after a shock. Comparing the mover–stayer and the Markov chain approaches to estimate the SME rating transition matrix, we find that the risk of a structural credit shock imposes flexible estimates not constrained by the long-run trajectory of borrowers. Improved migration estimation mitigates adverse selection in banks’ lending behavior. This conclusion is particularly true during economic downturns with the consequence of reducing the cyclicality and empowering the resilience of banks.

Keywords: Credit risk; Markov chains; absorbing state; rating migration (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1142/S2010139222400031

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