Coping with credit risk

Abstract

Purpose

This paper aims to propose a new method for credit risk allocation among economic agents.

Design/methodology/approach

The paper considers a pool of bank loans subject to a credit risk and develops a method for decomposing the credit risk into idiosyncratic and systematic components. The systematic component accounts for the aggregate statistical difference between credit defaults in a given period and the long‐run average of these defaults.

Findings

The paper shows how financial contracts might be redesigned to allow for banks to manage the idiosyncratic component for their own accounts, while allowing the systematic component to be handled separately. The systematic component can be retained, passed off to the capital markets, or shared with the borrower. In the latter case, the paper introduces a type of floating interest rate, in which the rate is set in arrears, based on a composite index for the systematic risk. This increases the efficiency of risk sharing between borrowers, lenders and the capital market.

Practical implications

The paper has several practical implications that are of value for financial engineers, loan market participants, financial regulators, and all economic agents concerned with credit risk. It could lead to a new class of structured notes being traded in the market.

Originality/value

The paper also illustrates the potential benefits of risk decomposition. Of course, as with any innovation, the implementation of the structured contracts would raise practical issues not addressed here. The paper also makes several simplifications: market risk is ignored; the level of default is constant and identical among borrowers. These simplifications could be lifted in future research on this theme.

Citation

Loubergé, H. and Schlesinger, H. (2005), "Coping with credit risk", Journal of Risk Finance, Vol. 6 No. 2, pp. 118-134. https://doi.org/10.1108/15265940510585798