Credit risk measurement and procyclicality

Abstract

This paper examines the two-way linkages between credit risk measurement and the macroeconomy. It first discusses the issue of whether credit risk is low or high in economic booms. It then reviews how macroeconomic considerations are incorporated into credit risk models and the risk measurement approach that underlies the New Basel Capital Accord. Finally, it asks what effect these measurement approaches are likely to have on the macroeconomy, particularly through their role in influencing the level of bank capital. The paper argues that much remains to be done in integrating macroeconomic considerations into risk measurement, particularly during the upswing of business cycles that are characterised by rapid increases in credit and asset prices. It also suggests that a system of risk-based capital requirements is likely to deliver large changes in minimum requirements over the business cycle, particularly if risk measurement is based on market prices. This has the potential to increase the financial amplification of business cycles, although other aspects of risk-based capital requirements are likely to work in the other direction. Further work on evaluating the net effects is important for both supervisory and monetary authorities.