Pederzoli, Chiara and Costanza Torricelli, "Capital Requirements and Business Cycle Regimes: Forward-looking modelling of default probabilities", Journal of Banking & Finance, Vol. 29, No. 12, (December 2005), pp. 3121-3140.
Abstract: This paper proposes a forward-looking model for time-varying capital requirements, which finds application within Basel II. The model rests on the relationship between default rates and the business cycle: by positing two regimes, expansion and recession, and by forecasting the associated probabilities, the default probability for each rating class is defined as the expected value of a default rate whose distribution is a mixture of an expansion and a recession distribution. The application to US data over the forecasting period 1971-2002 provides evidence that the model makes it possible to preserve the risk sensitivity of the capital requirement and at the same time to dampen procyclicality.
Keywords: Basel II, Capital requirement, Default probability, Business cycle, Procyclicality.