Bank-sourced transition matrices: Are banks' internal credit risk estimates Markovian?

This study provides new insights into banks' credit risk models by exploring features of their credit risk estimates and assessing practicalities of transition matrix estimation and related assumptions. Using a unique dataset of internal credit risk estimates from twelve global A-IRB banks, covering monthly observations on 20,000 North American and EU large corporates over the 2015-2018 time period, the study empirically tests the widely used assumptions of the Markovian property and time homogeneity at a larger scale than previously documented in the literature. The results show that internal credit risk estimates do not satisfy these assumptions as they show evidence of both path-dependency and time heterogeneity. In addition, contradicting previous findings on credit rating agency data, banks tend to revert their rating actions.