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

Mohammad Pesaran, Til Schuermann and Björn-Jakob Treutler

Cambridge Working Papers in Economics from Faculty of Economics, University of Cambridge

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.

Keywords: Risk management; default dependence; economic interlinkages; portfolio choice (search for similar items in EconPapers)
JEL-codes: C32 E17 G20 (search for similar items in EconPapers)
Pages: 53
Date: 2005-05
New Economics Papers: this item is included in nep-bec, nep-fin, nep-geo, nep-mac, nep-rmg and nep-ure
Note: EM
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Related works:
Working Paper: The Role of Industry, Geography and Firm Heterogeneity in Credit Risk Diversification (2005)
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Persistent link: https://EconPapers.repec.org/RePEc:cam:camdae:0529

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