Forward-Looking Estimation of Default Probabilities with Italian Data

by Giuseppe Marotta of the University of Modena and Reggio Emilia,
Chiara Pederzoli of the University of Milano Bicocca, and
Costanza Torricelli of the University of Modena and Reggio Emilia

November 2005

Abstract: The solution adopted in Basel II to deal with procyclicality of capital requirements implies a reduction in risk-sensitivity that contradicts the original spirit of the document. To preserve risk-sensitivity and to dampen procyclicality at the same time, Pederzoli and Torricelli (2005) set up a model based on a business cycle forecast in the estimation of the default probability and provide an application for the US. This paper checks the robustness of the approach with Italian data, where alternative business cycles chronologies are used and ratings have to be approximated. Findings suggest that the model performance depends on the chronology used.

JEL Classification: G21, G28, E32.

Keywords: Basel II, business cycle, capital requirement, default probability, procyclicality.

Published in: Euro-Mediterranean Economics and Finance Review, Vol. 1, No. 1, (January 2006), pp. 6-19.

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