Introduction

Understanding the degree of dependence among loan defaults in a bank’s loan portfolio is essential for accurate credit risk assessment. The interrelation between default events can significantly impact the overall risk profile of the portfolio. In this chapter, we will explore the concept of dependence among loan defaults and its implications for the portfolio’s default rate.

Dependence among Loan Defaults

Loan defaults within a bank’s portfolio are rarely isolated events. Instead, they often exhibit a degree of interdependence. This means that the occurrence of default for one loan can influence the likelihood of default for other loans within the same portfolio. This phenomenon can be attributed to various factors, including economic conditions, industry trends, and shared risk factors.

Correlation and Dependence

Correlation is a key metric used to measure the degree of dependence between two variables. In the context of loan defaults, correlation assesses the extent to which the default of one loan is associated with the default of another loan. A positive correlation indicates that defaults tend to occur together, while a negative correlation suggests an inverse relationship.

Implications for Portfolio’s Default Rate

The degree of dependence among loan defaults has significant implications for the portfolio’s default rate. When defaults are positively correlated, a downturn in economic conditions or an industry-specific shock can lead to multiple defaults within the portfolio. As a result, the portfolio’s default rate may increase substantially, amplifying the overall credit risk.

Diversification Effect

On the other hand, negative correlation or low correlation among defaults can offer a diversification effect. Diversification involves spreading investments across different assets to reduce risk. In the context of credit risk, a well-diversified portfolio may experience fewer simultaneous defaults during adverse events, potentially mitigating the impact on the default rate.

Example: Consider a bank with a loan portfolio that includes loans to various industries such as manufacturing, technology, and real estate. During an economic downturn, the manufacturing industry experiences a sharp decline, leading to default in several manufacturing-related loans. If there is high positive correlation among these defaults, the portfolio’s default rate would rise substantially. Conversely, if there is low correlation, the impact on the default rate may be more moderate.