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Credit risk enhancement in a network of interdependent firms

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  • Neu, Peter
  • Kühn, Reimer
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    Abstract

    We generalize existing structural models for credit risk to capture the impact of counterparty defaults on economic capital allocated to banks’ loan portfolios. Exploring the analogy to a lattice gas model from physics, correlations between sequential defaults are modeled as due to functionally defined, heterogeneous couplings between mutually dependent counterparties. We show that—already for moderate micro-economic dependencies—counterparty risk results in a fattening of the tails in the portfolio loss distribution. In particular, for stronger mutually supportive relationship between the firms, collective phenomena such as bursts and avalanches of defaults can be observed in the model. In this context, traditional credit risk models are inadequate because they underestimate the required capital buffer. Our model setting is particularly applicable for doing stress analyses of credit risk in loan portfolios.

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    File URL: http://www.sciencedirect.com/science/article/pii/S0378437104007113
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    Bibliographic Info

    Article provided by Elsevier in its journal Physica A: Statistical Mechanics and its Applications.

    Volume (Year): 342 (2004)
    Issue (Month): 3 ()
    Pages: 639-655

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    Handle: RePEc:eee:phsmap:v:342:y:2004:i:3:p:639-655

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    Web page: http://www.journals.elsevier.com/physica-a-statistical-mechpplications/

    Related research

    Keywords: Credit portfolio risk measurement; Contagion; Correlation; Capital allocation;

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    Cited by:
    1. Diana Barro & Antonella Basso, 2008. "A network of business relations to model counterparty risk," Working Papers 171, Department of Applied Mathematics, Università Ca' Foscari Venezia.
    2. Sebastian Heise & Reimer Kuehn, 2012. "Derivatives and Credit Contagion in Interconnected Networks," Papers 1202.3025, arXiv.org.
    3. Antonella Basso & Riccardo Gusso, 2008. "A credit contagion model for the dynamics of the rating transitions in a SME bank loan portfolio," Working Papers 162, Department of Applied Mathematics, Università Ca' Foscari Venezia.
    4. Lee, Sangwook & Kim, Min Jae & Lee, Sun Young & Kim, Soo Yong & Ban, Joon Hwa, 2013. "The effect of the subprime crisis on the credit risk in global scale," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 392(9), pages 2060-2071.
    5. Jean-Philippe Bouchaud, 2011. "Panel Statement: The endogenous dynamics of markets: price impact and feedback loops," Chapters, European Central Bank.
    6. Barro, Diana & Basso, Antonella, 2010. "Credit contagion in a network of firms with spatial interaction," European Journal of Operational Research, Elsevier, vol. 205(2), pages 459-468, September.
    7. Pawe{\l} Sieczka & Didier Sornette & Janusz A. Ho{\l}yst, 2010. "The Lehman Brothers Effect and Bankruptcy Cascades," Papers 1002.1070, arXiv.org, revised Sep 2011.

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