Cyclical Effects in Credit Risk Ratings and Default Risk*

It has long been recognised that banking is a procyclical business. That is, banks tend to contract their lending activity when there are business downturns because of their concern about loan quality and repayment probability. This exacerbates the economic downturn as credit constrained businesses and individuals cut back on their real investment activity. In contrast, banks expand their lending activity during boom periods, thereby contributing to a possible overheating of the economy that may transform an economic expansion into an inflationary spiral. The proliferation of credit risk measurement models in banking may accentuate the procyclical tendencies of banking, with potential macroeconomic consequences. The credit risk models’ overly optimistic estimates of default risk during boom times reinforces the natural tendency of banks to over-lend just at the point in the business cycle that the central bank prefers restraint. Moreover, if credit risk models are unduly pessimistic during recessions, then even the most expansionary monetary policy may not encourage banks to lend to obligors that are perceived to be poor credit risks. While the Bank for International Settlements (BIS) proposals do not allow the use of full-blown credit models, recent proposals provide for some aspects of credit risk models to be used as a basis for bank capital requirements. However, these proposals may further accentuate the procyclical nature of banking unless the credit cycle and its effect on credit risk are appropriately recognised in the model structure. If banks are constrained by risk-sensitive (as measured by internal models) capital allocations and regulatory requirements, they may be unable to lend during low points in the business cycle and may be overly encouraged to lend during boom periods. This is because risk-sensitive capital requirements (eg, risk adjusted return on capital (RAROC)-based approaches as performance measurement tools) increase (decrease) when estimates of default risk increase (decrease). Thus, if credit risk models overstate (understate) default risk in bad (good) times, then internal bank capital requirements will be too high (low) in bad (good) times, thereby forcing capital-constrained banks to retrench on lending during recessions and expand lending during booms. As stated by Andrew Crockett, the General Manager of the BIS, in a lecture at the HKMA Distinguished Lecture in Hong Kong on February 13, 2001: “[U]nderlying risk builds up as expansion and leverage continues, while apparent risk declines, with the rise in collateral values ... [R]isk increases during