Coping with Credit Risk
We consider a pool of bank loans subject to a credit risk and develop a method for decomposing the credit risk into idiosyncratic and systemic components. The systemic component accounts for the aggregate statistical difference between credit defaults in a given period and the long-run average of these defaults. We show how financial contracts might be redesigned to allow for banks to manage the idiosyncratic component for their own accounts, while allowing the systemic component to be handled separately. The systemic component can be retained, passed off to the capital markets, or shared with the borrower. In the latter case, we introduce a type of floating rate interest, in which the rate is set in arrears, based on a composite index for the systemic risk. This is shown to increase the efficiency of risk sharing between borrowers, lenders and the capital market.
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