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Essays on Bank Credit Risk, Capital Requirement and Business Cycle

Author: LiuZhiGang
Tutor: LiuJinQuan
School: Jilin University
Course: Quantitative Economics
Keywords: credit risk capital requirement business cycle recovery risk procyclicality
CLC: F224
Type: PhD thesis
Year: 2008
Downloads: 1584
Quote: 9
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In the past 30 years, the study of credit risk has become a very important area of finance. Since 1970s, the study on default risk bond pricing has brought credit risk study a revolutionary progress with plenty of innovation in theory and important development in quantitative analysis and modeling. Credit risk is the major operating risk of commercial banks that live on credit assets. The credit risk of bank loans is determined by individual factors like the borrower’s assets value, operations and performance will and systematic factors like macroeconomic cycle. Establishing a rational and effective quantitative model to accurately measure and manage credit risk is valuable in theory and significant in practice.Due to the important role banking plays in the economic and financial stability banking supervision came into being. Basel Committee on Banking Supervision and Basel Capital Accord are designed to exert banking supervision and constraint action by banking supervision authorities of major developed countries in the environment of financial globalization. The minimum capital requirement for banks is the focus of 1998 version and 2004 version of the Basel Capital Accord and is mainly for the measurement of credit risk and the allocation of capital. Therefore measurement and management of credit risk is important for banks to meet external regulatory requirements and to implement an effective internal management of economic capital.Starting from the capital function and capital feature of commercial banks, this paper sets out in detail and distinguishes the two important concepts of regulatory capital and economic capital and their roles in risk management of banks and focuses on the measurement method of economic methods and the measurement basis of regulatory capital, which leads to the study on credit risk and its elements. This paper recalls the important theoretical innovations and research achievements in the modern study of credit risk and explains the revaluation methods of default risk in the structured model and simplified model of credit risk, which are the basic tool for the measurement of economic capital and regulatory capital. Based on the analysis of credit risk formation mechanism and theoretical modeling, this paper focuses on a few important issues of current research on credit risk, such as default risk measurement, estimation of loss given default (LGD) and the relativity between PD (probability of default) and LGD and analyzes the role and impact of risk factors on capital requirements. Additionally, integrating credit risk with macroeconomics this paper makes an analysis on credit risk in the condition of business cycle and tests the interaction and correlation of credit risk, capital requirement and business cycle.Theoretical exploration and experiential analysis is made on especially on the hot and difficult issues in the current credit risk research, that is, recovery risk or LGD. This paper analyzes the impact elements, distribution features and modeling methods of recovery risk and makes a deep study on its dynamic features. Embedding recovery risk into credit risk model, this paper measures credit risk more comprehensively and more properly with default risk to provide tool support and research reference for accurately quantifying regulatory capital under BaselⅡ.The correlation of default rate and recovery rate and its impact on the calculation of economic capital and regulatory capital is increasing important in theoretical research. This paper pervasively analyzes the existence and source of the correlation and makes the estimation and validation of the correlation using model method, thereby evaluates the impact of correlation on capital measurement. In the study of LGD, based on the value change of collateral assets, the estimation and forecast of recovery rate is formed with combining macro systematic elements into the model. The concurrence of systematic elements on default risk and recovery risk is the main reason to produce the positive correlation of PD and LGD (or the negative correlation of PD and LGD).When studying the important correlation, we introduce default rate and recovery rate into the model at the same time, separate system risk factors and estimate the reflection intensity of default rate and recovery rate on system risk function. The findings are that the correlation of default rate and recovery rate with system risk is remarkable, but the correlation of default rate with system risk is influenced by samples. As a whole, default rate changes against system risk, while recovery rate changes along with system risk. The synchronized reflection of the two on macro system risk explains the internal reason for the positive correlation of PD/LGD.In the empirical analysis, we target on default bond to analyze the correlation between default rate and recovery rate and introduce default bond market variables and macroeconomic variables to consider the impact of supply and demand of default bond. The findings are that the impact of default bond market on recovery rate is remarkable, but the explanatory ability of macroeconomic factor on recovery rate is weak. Either in single-factor model or in double-factor model, default rate has good explanatory ability on recovery rate. The complexity and particularity in forming credit risk requires to introduce macroeconomic factor into the model, that is, to analyze the impact of macroeconomic factor, especially business cycle on default risk and recovery risk. This paper brings macroeconomic variables into credit risk factors in empirical analysis to test the action relation and impact direction of default risk and macroeconomic risk.Macroeconomic factors like business cycle status have significant influence on credit risk, which is represented by the fact that distribution features of credit risk factors like PD and LGD are quite different on different phases of business cycle. When the economy is expanding, the average PD and LGD of risk bonds and loans are comparably low, while during the recession of economy, they are comparably high.Through the dynamic correlation analysis, the dynamic correlation coefficient tracks of default and macroeconomic output variables in level, trend and cycle show that level variables and trend variables are remarkably negative correlative regardless lagging behind or ahead and the correlation is stable. Business cycle indicator by industrial output growth rate is distinctly negative correlative with default rate.Macroeconomic and business cycle indicator has good explanatory and predictive ability on default rate. Default rate of loans arises due to decrease in industrial output and distress experienced by enterprises and increase in bankruptcy. Granger influence relation test result further supports the above conclusion and illustrates the influence relation between macroeconomic condition and default rate in a quantitative view.This paper combines credit risk and macro-economic factors, as well as economic capital and regulatory capital so as to study the interaction and influence relation of credit risk, capital requirement and business cycle from a higher level. It is to analyze the source of procyclicality and to disclose the mechanism of procyclicality effect using theoretical analysis and empirical model. Credit supply fluctuation is a major reason to cause macroeconomic fluctuation, which is the representation of the impact of finance on macroeconomy as a kind of“accelerator”. Procyclicality effect is related to monetary policy and capital requirement of banking regulation.The interaction and influence relation between capital requirement and business cycle promote banks to reduce the supply of loan to meet the requirement of regulatory capital during the recession of economy. Shortage of loan supply decreases the productive ability of real economy and as a result worsens the recession. On the contrary, weak credit risk has smaller requirement of capital when economy is expanding and banks are inclined to increase the supply of loan, which accelerates the speed of economic expansion. The mechanism between capital requirement and business cycle enlarges the fluctuation of business cycle. In addition, on different stages of business cycle, procyclicality effect of credit risk on macro-economy through capital requirement might not be symmetric mainly because the extent of capital requirement worsening economy recession is larger than that of procyclicality effect promoting economy during economy expansion.Empirical study analyzes the influence relation of default rate, loan supply and economic growth rate and validates that default rate has a significant impact on loan supply as a result of risk sensitivity of capital requirement and that loan supply also has strong positive impact on economic growth. Formally, changes of default rate and LGD influence business cycle. Actually, default rate and LGD do not impose a direct impact on macro-economy but to realize it through monetary supply with risk sensitivity of capital requirement based on default rate and LGD as the important medium.

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CLC: > Economic > Economic planning and management > Economic calculation, economic and mathematical methods > Economic and mathematical methods
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