Ratings Migration and the Business Cycle, With Application to Credit Portfolio Stress Testing

Anil Bangia, Francis Diebold and Til Schuermann

Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania

Abstract: The turmoil in the capital markets in 1997 and 1998 has highlighted the need for systematic stress testing of banks' portfolios, including both their trading and lending books. We propose that underlying macroeconomic volatility is a key part of a useful conceptual framework for stress testing credit portfolios, and that credit migration matrices provide the specific linkages between underlying macroeconomic conditions and asset quality. Credit migration matrices, which characterize the expected changes in credit quality of obligors, are cardinal inputs to many applications, including portfolio risk assessment, modeling the term structure of credit risk premia, and pricing of credit derivatives. They are also an integral part of many of the credit portfolio models used by financial institutions. By separating the economy into two states or regimes, expansion and contraction, and conditioning the migration matrix on these states, we show that the loss distribution of credit portfolios can differ greatly, as can the concomitant level of economic capital to be assigned.

Keywords: Credit risk; stress testing; ratings migration; credit portfolio management (search for similar items in EconPapers)
JEL-codes: G11 G21 G28 (search for similar items in EconPapers)
Date: 2000-04
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Citations: View citations in EconPapers (30)

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Journal Article: Ratings migration and the business cycle, with application to credit portfolio stress testing (2002)
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