Credit Rating Migration Risk and Business Cycles

Basel III seeks to improve the financial sector’s resilience to stress scenarios which calls for a reassessment of banks’ credit risk models and, particularly, of their dependence on business cycles. This paper advocates a Mixture of Markov Chains (MMC) model to account for stochastic business cycle effects in credit rating migration risk. The MMC approach is more efficient and provides superior out‐of‐sample credit rating migration risk predictions at long horizons than a naïve approach that conditions deterministically on the business cycle phase. Banks using the MMC estimator would counter‐cyclically increase capital by 6% during economic expansion and free up to 17% capital for lending during downturns relative to the naïve estimator. Thus, the MMC estimator is well aligned with the Basel III macroprudential initiative to dampen procyclicality by reducing the recession‐versus‐expansion gap in capital buffers.