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The Role of Industry, Geography and Firm Heterogeneity in Credit Risk Diversification

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  • Pesaran, M.H.
  • Schuermann, T.
  • Treutler, B-J.

Abstract

In theory the potential for credit risk diversification for banks could be substantial. Portfolio diversification is driven broadly by two characteristics: the degree to which systematic risk factors are correlated with each other and the degree of dependence individual firms have to the different types of risk factors. We propose a model for exploring these dimensions of credit risk diversification: across industry sectors and across different countries or regions. We find that full firm-level parameter heterogeneity matters a great deal for capturing differences in simulated credit loss distributions. Imposing homogeneity results in overly skewed and fat-tailed loss distributions. These differences become more pronounced in the presence of systematic risk factor shocks: increased parameter heterogeneity greatly reduces shock sensitivity. Allowing for regional parameter heterogeneity seems to better approximate the loss distributions generated by the fully heterogeneous model than allowing just for industry heterogeneity. The regional model also exhibits less shock sensitivity.

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Bibliographic Info

Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 0529.

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Length: 53
Date of creation: May 2005
Date of revision:
Handle: RePEc:cam:camdae:0529

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Related research

Keywords: Risk management; default dependence; economic interlinkages; portfolio choice;

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  1. Amato, Jeffery D. & Furfine, Craig H., 2004. "Are credit ratings procyclical?," Journal of Banking & Finance, Elsevier, Elsevier, vol. 28(11), pages 2641-2677, November.
  2. Edward I. Altman, 1968. "Financial Ratios, Discriminant Analysis And The Prediction Of Corporate Bankruptcy," Journal of Finance, American Finance Association, American Finance Association, vol. 23(4), pages 589-609, 09.
  3. Anil Bangia & Francis X. Diebold & Til Schuermann, 2000. "Ratings Migration and the Business Cycle, With Application to Credit Portfolio Stress Testing," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 00-26, Wharton School Center for Financial Institutions, University of Pennsylvania.
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Cited by:
  1. George Kapetanios & M. Hashem Pesaran, 2005. "Alternative Approaches to Estimation and Inference in Large Multifactor Panels: Small Sample Results with an Application to Modelling of Asset Returns," CESifo Working Paper Series 1416, CESifo Group Munich.
  2. Masschelein, Nancy & Düllmann, Klaus, 2006. "Sector concentration in loan portfolios and economic capital," Discussion Paper Series 2: Banking and Financial Studies 2006,09, Deutsche Bundesbank, Research Centre.

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