The objective of this paper is to measure the cyclicality of risk weights, calculated according to Basel II IRB approach, for SME corporate portfolio of one Nordic bank. Our main focus is to examine effects of both the loan allocation within the portfolio and the bank's rating system in calculating risk weights, and to estimate which of these effects predominates. In this paper an econometric model, a first-order autoregressive model, is designed to measure business cycle sensitivity of a rating system. The model measures sensitivity by estimating elasticities of default probabilities with respect to realised default rates. The analysis of default rates, based on the correlation of default rates and GDP is also carried out in order to measuse the rating system's sensitivity to the business cycle. In this paper we also simulate a fully sensitive to the business cycle system and a fairly neutral to the business cycle system in order to examine the effect of loan allocation and the effect of rating systems' sensitivity on risk weights.
The main conclusion in this paper is that the countercyclical effect of loan reallocation within one particular bank's portfolio for corporates predominates the procyclical effect of changes in the borrowers' creditworthiness over the business cycle. Calculated risk weights for this portfolio move in a countercyclical manner as a result of the bank's credit policy and the low business cycle sensitivity of the bank's rating system. The results show that the effect of loan allocation has a great impact even in the case with the simulated fully sensitive to the business cycle system. Another finding of this paper is that changes in the bank's credit policy are first and foremost applied on new borrowers, i.e.the bank sets higher thresholds for granting loans in economic downturns.