Introduction

Abstract

Research on the determinants of recovery in default shows that there is a systematic component in recovery risk and that in times of financial distress and rising default rates, recovery rates tend to be particularly low. This has important ramifications for credit risk management and stress testing: Altman, Brady, Resti, and Sironi (2005) estimate that assuming constant recovery rates or independence from systematic factors underestimates value at risk, and hence economic capital, by approximately 30%. In its framework documentation on capital measurement and capital standards (Basel II), the Basel Committee on Banking Supervision accordingly demands that recovery estimates “reflect economic downturn conditions where necessary to capture the relevant risks”.