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Correlations and Business Cycles of Credit Risk: Evidence from Bankruptcies in Germany

by Daniel Rösch of the University of Regensburg

November 2002

Abstract: A major topic in empirical finance is correlation of default risk. Correlations are the main drivers for credit risk on a portfolio basis and for banks' capital requirements under the New Basel Accord. However, empirical evidence on the magnitude of correlations is rather scarce, mainly due to data limitations. Using a large database of bankruptcies in Germany we estimate correlations using a simple version of the Basel II factor model. Then we extend the model to an approach with observable risk factors and suggest that this model with default probabilities depending on the state of the economy may be more adequate. Empirical evidence on proxies for the credit cycles is presented for German industry sectors. We find that much of the co-movements can be explained by our variables. Finally, we discuss some implications for forecasts of distributions of potential future defaults of a bank's portfolio.

JEL Classification: G20, G28, C51.

Keywords: Credit Risk, Bankruptcy, Correlations, Basel II.

Published in: Financial Markets and Portfolio Management, Vol. 17, No. 3, (September 2003), pp. 309-331.

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