Esa Jokivuolle's paper accepted in Journal of Financial Stability
“Cyclical default and recovery in stress testing loan losses” by Esa Jokivuolle (Aalto University and Bank of Finland) and Matti Virén (University of Turku and Bank of Finland) was accepted for publication in Journal of Financial Stability.
We present a macro variable-based empirical model for corporate bank loans' credit risk. The model captures the well-known positive relationship between probability of default (PD) and loss given default (LGD; ie, the inverse of recovery) and their counter-cyclical movement with the business cycle. In the absence of proper micro data on LGD, we use a random-sampling method to estimate the annual average LGD. We specify a two equation model for PD and LGD which is estimated with Finnish time-series data from 1989-2008. We also use a system of time-series models for the exogenous macro variables to derive the main macroeconomic shocks which are then used in stress testing aggregate loan losses. We show that the endogenous LGD makes a considerable difference in stress tests compared to a constant LGD assumption.