Abstract

Financial institutions have experienced various difficulties for many years; this is the main reason why every bank should be aware of its credit risk evolution in order to set objectives governing the bank’s lending. The purpose of our paper is to characterise the credit quality of US banks using transition probability matrices constructed using Markov chains. The stationarity of credit migration probability is conditioned by macroeconomic development and monetary policy. We monitor the likelihood of migration among credit classes based on short-term trends in output gap and the Fed Fund rate. We claim that there is a certain relation between the two monitored parameters and the credit standards of the clients. In addition, we found evidence of the market’s lessons from the global financial crisis in 2008 when the markets did not capture a deterioration in credit quality.