Default and recovery correlations - a dynamic econometric approach

Integrating coherences between defaults and loss given default (LGD) is postulated by Basel II. If there is a positive correlation between the two, separate models for each lead to biased estimates for the LGD parameters, and the economic loss is overestimated. Alfred Hamerle, Michael Knapp and Nicole Wildenauer show that the bias vanishes if a simultaneous approach is used, leading to lower predicted LGDs and thus lower regulatory and economic capital requirements

In credit risk models, the loss given default (LGD)1 is either incorporated deterministically (as in Credit Risk+) or stochastically (as in CreditMetrics). In the latter case, the LGD may be drawn from a beta distribution.2 In both cases, no correlation between default and LGD is considered.

In economic downturns, not only do probabilities of default (PDs) increase, but recovery rates also decrease. This pattern can be seen in historical data (see, for example, Frye, 2000, or Altman et al, 2003)