Exploring the mismatch between credit ratings and loss-given-default: A credit risk approach |
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Institution: | 1. School of Management and Economics, University of Electronic Science and Technology of China, No. 2006, Xiyuan Av, Chengdu, 611731, PR China;2. College of Economics & Management, Northwest A&F University, No. 3 TaiCheng Road, Yangling, Shaanxi 712100, PR China;3. School of Management Science and Engineering, Dongbei University of Finance & Economics, Jianshan Street 217, Dalian 116025, PR China;4. School of Business, Worcester Polytechnic Institute, 100 Institute Road, Worcester, MA 01609-2280, USA;1. School of Economics and Business Engineering, Karlsruhe Institute of Technology, Germany;2. Departments of Computer and Electrical Engineering, Ferdowsi University of Mashhad, Iran;3. EDHEC Business School, Nice, France |
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Abstract: | It is commonly observed that high grade loans with better ratings are often associated with low recoveries if they default (i.e. with relatively high loss-given-default (LGD)). To address the mismatch problem, this paper proposes a credit risk approach by minimizing LGD for higher rated loans as a risk-rating matching standard in the sense that the decreasing LGD from creditors’ perspective is associated with higher credit rating for the borrower. This standard forces customers’ credit rating of each grade to be optimally determined in correspondence to its LGD, which means the LGD of high grade loans tends to be low. The approach is then tested using three credit datasets from China, i.e. credit data from 2044 farmers, 2157 small private businesses and 3111 SMEs. The empirical results show that the proposed approach indeed guides the way to solve the mismatch phenomenon between credit ratings and LGDs in the existing credit rating literature. By optimally determining credit ratings, the findings derived from this paper help provide a valuable reference for bankers, and bond investors to manage their credit risk. |
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Keywords: | Credit rating Loss-given-default Credit rating matching Microfinance loan China G24 G32 C61 |
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