By employing Moody’s corporate default and rating transition data spanning the last 90years we explore how much capital banks should hold against their corporate loan portfolios to withstand historical stress scenarios. Specifically, we will focus on the worst case scenario over the observation period, the Great Depression. We find that migration risk and the length of the investment horizon are critical factors when determining bank capital needs in a crisis. We show that capital may need to rise more than three times when the horizon is increased from 1year, as required by current and future regulation, to 3years. Increases are still important but of a lower magnitude when migration risk is introduced in the analysis. Further, we find that the new bank capital requirements under the so-called Basel 3 agreement would enable banks to absorb Great Depression-style losses. But, such losses would dent regulatory capital considerably and far beyond the capital buffers that have been proposed to ensure that banks survive crisis periods without government support.

The distribution of ratings changes plays a crucial role in many credit risk models. As is well-known, these distributions vary across time and different issuer types. Ignoring such dependencies may lead to inaccurate assessments of credit risk. In this paper, we quantify the dependence of rating transition probabilities on the industry and domicile of the obligor, and on the stage of the business cycle. Employing ordered probit models, we identify the incremental impact of these factors. Our approach gives a clearer picture of which conditioning factors are important than comparing transition matrices estimated from different sub-samples.

This paper investigates the role of credit and liquidity factors in explaining corporate CDS price changes during normal and crisis periods. We find that liquidity risk is more important than firm-specific credit risk regardless of market conditions. Moreover, in the period prior to the recent “Great Recession” credit risk plays no role in explaining CDS price changes. The dominance of liquidity effects casts serious doubts on the relevance of CDS price changes as an indicator of default risk dynamics. Our results show how multiple liquidity factors including firm specific and aggregate liquidity proxies as well as an asymmetric information measure are critical determinants of CDS price variations. In particular, the impact of informed traders on the CDS price increases when markets are characterised by higher uncertainty, which supports concerns of insider trading during the crisis.

We analyse a sample of 6 million firm-year observations of large corporations and small and medium sized enterprises (SMEs) spanning 6 European countries from 2005 to 2015, to determine the impact of leverage and different sources of funding on default risk. We find that financial leverage has a greater impact on the probability of default of SMEs than of large corporations. The difference in default probability between the top and bottom leverage quartiles is 1.24% for large firms and 2.87% for SMEs. This difference may be explained by the greater exposure of SMEs to short-term debt and their consequently higher refinancing risk. Indeed, we find that SMEs that recover from the state of insolvency may have similar leverage to defaulted SMEs; however their liability structure is significantly altered towards long-term debt and away from short-term debt. Our findings have important implications not only for bank regulators and policy-makers but also for credit risk modelling.

We investigate the impact of deregulation-induced banking competition on corporate credit risk. Although banking competition does not, on average, affect corporate bankruptcy rates, we find that it causes corporate bankruptcies to increase significantly for high-leverage firms. We show that higher borrowing costs for high-leverage firms post-deregulation and the resulting credit rationing may be key factors behind our findings. The effect of deregulation lasts for up to seven years after the introduction of deregulation and originates mainly from firms that have high short-term debt and are financially constrained. Our results suggest that banking competition, which is expected to expand lending and reduce its cost, may, in fact, create more challenging credit conditions, particularly for firms that are more heavily dependent on external funding.

We study the impact that lower complexity in bank securitisations has on mortgage quality and the securitisation structure. We find that mortgages issued after the announcement of new European regulation that aims to reduce deal complexity are characterised by up to 0.38% lower annual delinquency rates than in the pre-regulation period. Similarly, we show that mortgage securitisations that meet the new ‘simplicity, transparency and standardisation’ (STS) criteria have 0.77% lower annual delinquency rates and are more resilient to adverse macro-economic shocks. We find that the increased quality of the underlying loans outweighs the potential negative effects of thinner subordinated tranches in securitisations that comply with the new regulation. Overall, our findings suggest that the new European securitisation regulation has contributed to improving credit quality in the securitisation market in Europe.