Credit Risk and Macroeconomic Dynamics

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Credit Risk and Macroeconomic Dynamics

by M. Hashem Pesaran of the University of Cambridge, and
Til Schuermann of the Federal Reserve Bank of New York

March 2003

Abstract: Credit risk is the dominant source of risk for commercial banks and the subject of strict regulatory oversight and policy debate. This paper provides an overview of the conditional credit risk modeling approach set out in detail in Pesaran, Schuermann, Treutler and Weiner (2003). Asset value changes of a credit (loan) portfolio are linked to a dynamic global macroeconometric model, allowing macro effects to be isolated from idiosyncratic shocks from the perspective of default (and hence loss). The approach can be used, for example, to compute the effects of a hypothetical negative equity price shock in South East Asia on the loss distribution of a credit portfolio held by a commercial bank over one or more quarters. It is shown that the effects of such shocks on expected default are asymmetric and non-proportional, reflecting the highly nonlinear feature of the credit risk model. The proposed modeling approach has broad application potential in credit risk management and the pricing of risky assets such as credit derivatives.

Published in: Medium Econometrische Toepassingen, Vol. 11, No. 1, (March 2003), pp. 27-32.

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