FIN-02-049 |
NYU Stern School of Business |
The Link between Default and Recovery Rates:
Implications for Credit Risk Models and Procyclicality
July 2002
Edward I. Altman, Brooks Brady, Andrea Resti and Andrea Sironi
ABSTRACT
Abstract
This paper analyzes the impact of various assumptions about the association between aggregate default
probabilities and the loss given default on bank loans and corporate bonds, and seeks to empirically
explain this critical relationship. Moreover, it simulates the effects on mandatory capital requirements like
those proposed in 2001 by the Basel Committee on Banking Supervision. We present the analysis and
results in four distinct sections. The first section examines the literature of the last three decades of the
various structural-form, closed-form and other credit risk and portfolio credit value-at-risk (VaR) models
and the way they explicitly or implicitly treat the recovery rate variable. Section 2 presents simulation
results under three different recovery rate scenarios and examines the impact of these scenarios on the
resulting risk measures: our results show a significant increase in both expected and unexpected losses
when recovery rates are stochastic and negatively correlated with default probabilities. In Section 3, we
empirically examine the recovery rates on corporate bond defaults, over the period 1982-2000. We
attempt to explain recovery rates by specifying a rather straightforward statistical least squares regression
model. The central thesis is that aggregate recovery rates are basically a function of supply and demand
for the securities. Our econometric univariate and multivariate time series models explain a significant
portion of the variance in bond recovery rates aggregated across all seniority and collateral levels. Finally,
in Section 4 we analyze how the link between default probability and recovery risk would affect the
procyclicality effects of the New Basel Capital Accord, due to be released in 2002. We see that, if banks
use their own estimates of LGD (as in the "advanced" IRB approach), an increase in the sensitivity of
banks’ LGD due to the variation in PD over economic cycles is likely to follow. Our results have
important implications for just about all portfolio credit risk models, for markets which depend on
recovery rates as a key variable (e.g., securitizations, credit derivatives, etc.), for the current debate on the
revised BIS guidelines for capital requirements on bank credit assets, and for investors in corporate bonds
of all credit qualities.
Edward I. Altman
Institution: Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012
Telephone: (212) 998-0709
Email: ealtman@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~ealtman
Brooks Brady
Institution: Associate Professor of Finance, Department of Mathematics and Statistics, Bergamo University, Italy
Andrea Resti
Institution: Associate Director, Standard & Poor’s Risk Solutions Group.
Andrea Sironi
Institution: Professor of Financial Markets and Institutions and Director of the Research Division of SDA Business School, Bocconi
University, Milan, Italy
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