Pro-Cyclicality, Empirical Credit Cycles, and Capital Buffer Formation

Abstract

We model 1927-1997 U.S. business failure rates using a time series approach based on unobserved components. Clear evidence is found of cyclical behaviour in default rates. The cycle has a period of around 10 years. We also detect longer term movements in default rates and default correlations. In a credit risk experiment we show that accommodation of these default rate dynamics has important consequences for capitalisation requirements for credit risk. First, the static variants of credit risk portfolio models that are typically used by financial institutions and their regulators may significantly underestimate capital requirements for credit risk. Second, models that account for the observed dynamic behaviour of default rates do anticipate on required increases in capital, in contrast to models that only use recent historical default rate data. Hence, dynamic credit risk models may help to alleviate the problems of pro-cyclicality in capital requirements. Besides, we show that the size of the net margin is an important determinant of the level of capital needed. Ignoring the net margin in dynamic credit risk analyses may lead to overly conservative capital requirements.