Is Firm Interdependence Within Industries Important for Portfolio Credit Risk?

Sveriges Riksbank Working Paper No. 168

Riksbank Research Paper Series No. 11

33 Pages Posted: 14 Sep 2004

See all articles by Kenneth Carling

Kenneth Carling

Uppsala University

Lars Ronnegard

Dalarna University

Kasper Roszbach

Norges Bank - Research Department; University of Groningen - Faculty of Economics and Business

Date Written: August 2006


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, these models 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.

Keywords: Value-at-risk, credit risk, portfolio credit risk, duration model, default correlation, industry dependency, cluster errors

JEL Classification: C34, C35, D61, D81, G21

Suggested Citation

Carling, Kenneth and Ronnegard, Lars and Roszbach, Kasper F., Is Firm Interdependence Within Industries Important for Portfolio Credit Risk? (August 2006). Sveriges Riksbank Working Paper No. 168, Riksbank Research Paper Series No. 11, Available at SSRN: or

Kenneth Carling

Uppsala University ( email )

Office of Labour Market Policy Evaluation
SE-751 20 Uppsala
+46-18-4717087 (Phone)

Lars Ronnegard

Dalarna University ( email )

SE-788 81 Borlange
+46 23 77 85 58 (Phone)

Kasper F. Roszbach (Contact Author)

Norges Bank - Research Department ( email )

P.O. Box 1179
Oslo, N-0107

University of Groningen - Faculty of Economics and Business ( email )

Department of Economics, Econometrics and Finance
Nettelbosje 2
Groningen, NL 9747 AE


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