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Is Firm Interdependence within Industries Important for Portfolio Credit Risk?

  • Carling, Kenneth

    ()

    (IFAU, Uppsala and Dalarna University)

  • Rönnegård, Lars

    ()

    (Dalarna University)

  • Roszbach, Kasper

    ()

    (Research Department, Central Bank of Sweden)

A drawback of available portfolio credit risk models is that they fail to allow for default risk dependency across loans other than through common risk factors. Thereby, thesemodels ignore that close ties can exist between companies due to legal, financial and business relations. In this paper, we integrate the insights from theoretical models of default correlation into a commonly used model of default and portfolio credit risk by allowing for dependency between firm default risk through both common factors and industry specific errors in a duration model. An application using pooled data from two Swedish banks’ business loan portfolios over the period 1996-2000 shows that estimates of individual default risk are little affected by including industry specific errors. However, accounting for these industry effects increases VaR estimates by 50-200 percent. A traditional model with only systematic factors, although able to fit the broad trends in credit losses, cannot match these fluctuations because it fails to capture credit losses in bad times, when banks are typically hit by large unexpected credit losses. The model we propose manages to follow both the trend in credit losses and produce industry driven, time-varying, fluctuations in losses around that trend. Consequently, this model will better aid banks and regulators in determining the appropriate size of economic capital requirements. Capital buffers derived from our model will be larger for periods with large ”aggregate” disturbances and smaller in better times, and avoid both overcapitalization in good times and undercapitalization in bad times.

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Paper provided by Sveriges Riksbank (Central Bank of Sweden) in its series Working Paper Series with number 168.

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Length: 36 pages
Date of creation: 01 Aug 2004
Date of revision:
Handle: RePEc:hhs:rbnkwp:0168
Contact details of provider: Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden
Phone: 08 - 787 00 00
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  1. Kasper Roszbach, 2004. "Bank Lending Policy, Credit Scoring, and the Survival of Loans," The Review of Economics and Statistics, MIT Press, vol. 86(4), pages 946-958, November.
  2. Gordy, Michael B., 2000. "A comparative anatomy of credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 119-149, January.
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  8. Michael B. Gordy, 2002. "A risk-factor model foundation for ratings-based bank capital rules," Finance and Economics Discussion Series 2002-55, Board of Governors of the Federal Reserve System (U.S.).
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  12. Jacobson, Tor & Linde, Jesper & Roszbach, Kasper, 2006. "Internal ratings systems, implied credit risk and the consistency of banks' risk classification policies," Journal of Banking & Finance, Elsevier, vol. 30(7), pages 1899-1926, July.
  13. 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 00-26, Wharton School Center for Financial Institutions, University of Pennsylvania.
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  15. Carling, Kenneth & Jacobson, Tor & Linde, Jesper & Roszbach, Kasper, 2007. "Corporate credit risk modeling and the macroeconomy," Journal of Banking & Finance, Elsevier, vol. 31(3), pages 845-868, March.
  16. Edward I. Altman, 1973. "Predicting Railroad Bankruptcies in America," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 184-211, Spring.
  17. Linda Allen & Anthony Saunders, 2004. "Incorporating Systemic Influences Into Risk Measurements: A Survey of the Literature," Journal of Financial Services Research, Springer, vol. 26(2), pages 161-191, October.
  18. Viral V. Acharya & Iftekhar Hasan & Anthony Saunders, 2006. "Should Banks Be Diversified? Evidence from Individual Bank Loan Portfolios," The Journal of Business, University of Chicago Press, vol. 79(3), pages 1355-1412, May.
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  20. Carey, Mark & Hrycay, Mark, 2001. "Parameterizing credit risk models with rating data," Journal of Banking & Finance, Elsevier, vol. 25(1), pages 197-270, January.
  21. Giesecke, Kay, 2004. "Correlated default with incomplete information," Journal of Banking & Finance, Elsevier, vol. 28(7), pages 1521-1545, July.
  22. Platt, Harlan D. & Platt, Marjorie B., 1991. "A note on the use of industry-relative ratios in bankruptcy prediction," Journal of Banking & Finance, Elsevier, vol. 15(6), pages 1183-1194, December.
  23. Mark Carey, 1998. "Credit Risk in Private Debt Portfolios," Journal of Finance, American Finance Association, vol. 53(4), pages 1363-1387, 08.
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