This paper shows how credit quality transition matrices of loans to Italian firms changed during a cyclical downturn (2008-09), compared with a previous time of growth (2006-07). Once transition matrices were linked to interest rates, banks appear to have been remarkably able at calibrating required risk premiums to actual idiosyncratic risk, both during expansion and recession. However, the uncertainty generated by the crisis accentuated the unexpected component of credit worsening, thus lowering pricing effectiveness. The main finding is that larger banking groups were more affected by the sudden deterioration of credit quality than smaller ones, as far as ability to price risk is concerned. The bank-size effect can be tackled through an efficient use of hard or soft information: both rating users and decentralized banks showed an above-average ability in calibrating rates to risk during the crisis; banks with a stronger relationship with borrowers smoothed the risk-price curve in normal times.
Published in 2017 in: Economic Notes, Monte dei Paschi di Siena, v. 46, 2, pp. 171–206
