Credit Transition and Structural Shocks

Credit risk involves not only the complexity of screening but also monitoring and esti- mating rating transition. The adoption of inadequate transition matrices causes a mis- evaluation of credit risk, a consequent misallocation of capital, with the prospect that the lending process will be a®ected by increasing transaction costs and limited rationality, especially after a shock. Comparing the mover–stayer and the Markov chain approaches to estimate the SME rating transition matrix, we ¯nd that the risk of a structural credit shock imposes °exible estimates not constrained by the long-run trajectory of borrowers. Improved migration estimation mitigates adverse selection in banks' lending behavior. This conclusion is particularly true during economic downturns with the consequence of reducing the cyclicality and empowering the resilience of banks.