Correlations and Business Cycles of Credit Risk: Evidence from Bankruptcies in Germany
Financial Markets and Portfolio Management, Vol. 17, No. 3, 2003, pp. 309-331
28 Pages Posted: 10 Nov 2013
Date Written: 2003
Abstract
A major topic in empirical finance is correlation of default risk. Correlations are the main drivers for credit risk on a portfolio basis and for banks’ capital requirements under the New Basel Accord. However, empirical evidence on the magnitude of correlations is rather scarce, mainly due to data limitations. Using a large database of bankruptcies in Germany we estimate correlations using a simple version of the Basel II factor model. Then we extend the model to an approach with observable risk factors and suggest that this model with default probabilities depending on the state of the economy may be more adequate. Empirical evidence on proxies for the credit cycles is presented for German industry sectors. We find that much of the co-movements can be explained by our variables. Finally, we discuss some implications for forecasts of distributions of potential future defaults of a bank’s Portfolio.
Keywords: Credit Risk, Bankruptcy, Correlations, Basel II
JEL Classification: G20, G28, C51
Suggested Citation: Suggested Citation