Cyclical default and recovery in stress testing loan losses

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; i.e., 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 to 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.