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

54 Pages Posted: 11 Jun 2005

See all articles by M. Hashem Pesaran

M. Hashem Pesaran

University of Southern California - Department of Economics; University of Cambridge - Trinity College (Cambridge)

Björn-Jakob Treutler

Mercer Oliver Wyman

Til Schuermann

Oliver Wyman

Date Written: May 2005

Abstract

In theory the potential for credit risk diversifcation for banks could be substantial. Portfolios are large enough that idiosyncratic risk is diversifed away leaving exposure to systematic risk. The potential for portfolio diversifcation 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 diversifcation: 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

JEL Classification: C32, E17, G20

Suggested Citation

Pesaran, M. Hashem and Treutler, Björn-Jakob and Schuermann, Til, The Role of Industry, Geography and Firm Heterogeneity in Credit Risk Diversification (May 2005). IEPR Working Paper No. 05.25. Available at SSRN: https://ssrn.com/abstract=740426 or http://dx.doi.org/10.2139/ssrn.740426

M. Hashem Pesaran (Contact Author)

University of Southern California - Department of Economics

3620 South Vermont Ave. Kaprielian (KAP) Hall 300
Los Angeles, CA 90089
United States

University of Cambridge - Trinity College (Cambridge) ( email )

United Kingdom

Björn-Jakob Treutler

Mercer Oliver Wyman ( email )

Bleichstrasse 1
60313 Frankfurt
Germany
+49-69-97173-558 (Phone)
+49-69-955-12010 (Fax)

Til Schuermann

Oliver Wyman ( email )

1166 6th Avenue
New York City, NY
United States

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