Capital requirements and business cycle regimes: Forward-looking modelling of default probabilities

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. (c) 2005 Elsevier B.V. All rights reserved.