Bayesian clustering for portfolio credit risk

Bohdan Horak and Christoph Frei

Journal of Credit Risk

Abstract: Credit risk models for loan portfolios typically assume that exposures can be assigned to homogeneous risk buckets, as in Vasicek- and Basel-style portfolio credit risk models.We propose a Bayesian clustering model for constructing homogeneous risk buckets directly from loan credit histories. In contrast to traditional segmentation, the framework assigns weighted memberships across multiple clusters, capturing cross-sector and multifactor exposures more realistically. Using both simulated and real credit data, we find that the proposed method can improve the estimation of loss distributions, value-at-risk and expected shortfall. The approach provides a statistically robust and operationally tractable alternative to conventional bucketing, offering a more flexible foundation for portfolio credit risk management and capital assessment.

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