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S&P Report Looks At Relationship Between Default Rates And Recovery Over Time

As many banks are preparing to comply with Basel II requirements, the estimation of the main parameters for the Basel II framework, such as probability of default (PD), has become one of the major focuses for risk management in the banking industry. PD estimation is a relatively well-developed area within the Basel II framework.

There are volumes of academic research and commercial solutions regarding PD estimation. However, there has not been such progress in post-default recovery estimation due to data limitation. The default data is scarce, and collecting it is the most challenging aspect of any PD modeling. Tracking all post-default activities and recording the recovery value when the company has emerged from default can often take a few years to complete. As a result, there is only minimal academic research on recovery modeling. However, a report published earlier today by Standard & Poor's Risk Solutions, titled "The Relationship Between Default Rates And Recovery," contends that, over time, there is a "negative" relationship between PD and speculative-grade post-default recovery values (i.e., the higher the default rate, the lower the recovery rate, and vice versa). The article's conclusions are based on data collected from Standard & Poor's CreditPro® version 7.5 and Standard & Poor's LossStats® Database version 1.7.