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A Survey of Cyclical Effects in Credit Risk Measurement Models

by Linda Allen of the University of New York, and
Anthony Saunders of New York University

January 2003

Introduction: It has long been recognized that banking is a procyclical business. That is, banks tend to contract their lending activity when business turns down because of their concern about loan quality and repayment probability. This exacerbates the economic downturn as credit constrained businesses and individuals cut back on their real investment activity. In contrast, banks expand their lending activity during boom periods, thereby contributing to a possible overheating of the economy that may transform an economic expansion into an inflationary spiral.

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Gupton and Stein[2002] found that LGD is forecast by four time-series that measure aggregate default intensity, the health of both the broad economy and the debt markets, and aggregate default expectation (Table 1). In the LossCalc framework, these macro factors account for 26% of the explained variance in LGD (Figure 4).