The Role of Industry, Geography and Firm Heterogeneity in Credit Risk Diversification
AbstractIn theory the potential for credit risk diversifcation for banks could be substantial. Portfolios are large enough that idiosyncratic risk is diversifed away leaving exposure to systematic risk. The potential for portfolio diversifcation 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 diversifcation: across industry sectors and across di¤erent 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 InfoPaper provided by Institute of Economic Policy Research (IEPR) in its series IEPR Working Papers with number 05.25.
Length: 53 pages
Date of creation: May 2005
Date of revision:
Risk management; default dependence; economic interlinkages; portfolio choice;
Other versions of this item:
- Pesaran, M.H. & Schuermann, T. & Treutler, B-J., 2005. "The Role of Industry, Geography and Firm Heterogeneity in Credit Risk Diversification," Cambridge Working Papers in Economics 0529, Faculty of Economics, University of Cambridge.
- C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
- E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation: Models and Applications
- G20 - Financial Economics - - Financial Institutions and Services - - - General
This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-06-14 (All new papers)
- NEP-FIN-2005-06-14 (Finance)
- NEP-GEO-2005-06-14 (Economic Geography)
- NEP-MAC-2005-06-14 (Macroeconomics)
- NEP-RMG-2005-06-14 (Risk Management)
- NEP-URE-2005-06-14 (Urban & Real Estate Economics)
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