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Contagious defaults in credit portfolios: a network approach

27 May 2019
Ex-Boccherini Building (Piazza San Ponziano, 6) - Conference Room

Portfolio credit risk models estimate the range of potential losses due to defaults or deteriorations in credit quality.Robustness of these models is of great interest for financial institutions and regulators, since incorrectly specified models translate to insufficient capital buffers and a crisis-prone financial system. Most commonly used models perceive default correlation as fully captured by the dependence on some common underlying risk factors. In light of empirical evidence, the ability of such a conditional independence framework to accommodate for the occasional default clustering has been questioned repeatedly. Thus, financial institutions have relied on stressed correlations or alternative copulas with more extreme tail dependence. We propose a different remedy - augmenting systematic risk factors with a contagious default mechanism which affects the entire universe of credits. We construct credit stress propagation networks and estimate contagion parameters for infectious defaults. The resulting framework is implemented on synthetic test portfolios where the impact on the tails of the loss distributions is found to be significant.

Ioannis Anagnostou - University of Amsterdam