The determinants of bank loan recovery rates in good times and bad - new evidence

Abstract

We find that factors explaining bank loan recovery rates vary depending on the state of the economic cycle. Our modeling approach incorporates a two-state Markov switching mechanism as a proxy for the latent credit cycle, helping to explain differences in observed recovery rates over time. We are able to demonstrate how the probability of default and certain loan-specific and other variables hold different explanatory power with respect to recovery rates over `good' and `bad' times in the credit cycle. That is, the relationship between recovery rates and certain loan characteristics, firm characteristics and the probability of default differs depending on underlying credit market conditions. This holds important implications for modelling capital retention, particularly in terms of countercyclicality.