Splitting Credit Risk into Systemic, Sectorial and Idiosyncratic Components

Abstract

We provide a methodology to estimate a global credit risk factor from credit default swap (CDS) spreads that can be very useful for risk management. The global risk factor (GRF) reproduces quite well the different episodes that have affected the credit market over the sample period. It is highly correlated with standard credit indices, but it contains much higher explanatory power for fluctuations in CDS spreads across sectors than the credit indices themselves. The additional information content over iTraxx seems to be related to some financial interest rates. We first use the estimated GRF to analyze the extent to which the eleven sectors we consider are systemic. After that, we use it to split the credit risk of individual firms into systemic, sectorial, and idiosyncratic components, and we perform some analyses to test that the estimated idiosyncratic components are actually firm-specific. The systemic and sectorial components explain around 65% of credit risk in the European industrial and financial sectors and 50% in the North American sectors, while 35% and 50% of risk, respectively, is of an idiosyncratic nature. Thus, there is a significant margin for portfolio diversification. We also show that our decomposition allows us to identify those firms whose credit would be harder to hedge. We end up analyzing the relationship between the estimated components of risk and some synthetic risk factors, in order to learn about the different nature of the credit risk components.

How to estimate expected credit losses – ECL – for provisioning under IFRS 9

“…Qualitatively, the results presented in Table 1 are in line with many other studies on spread components (Longstaff et al , 2005; Chen et al , 2007; Lin et al , 2011; Chen et al , 2016; Arakelyan and Serrano, 2016; and Novales and Chamizo, 2019).…”

“…It is also worth noting that, differently from them, we provide a weight of default component for each forward term. In their turn, Novales and Chamizo (2019) find for IG companies in Europe and in North America that the idiosyncratic default risk component represents, on average, respectively, 35 and 50% of credit spread.…”

“…However, previous research focuses primarily on non-default components of credit spread. There exists a vast literature on liquidity component, quantifying it through diverse, relative and absolute liquidity metrics; see, for example, Arakelyan and Serrano (2016), Novales and Chamizo (2019), and the references therein. Under such approaches, the pure default compensation becomes rather a by-product, whereas our research presents the direct explicit empirical study of default risk premium for each forward term.…”

System risk management policy in banking

“…The main transitional goal of preventive instruments used in the phase of accumulation of the time component of system risk is to increase the resilience of the financial system by creating reserves that are then used in the period of materialization of this risk (Novales & Chamizo, 2019). Sufficient protective capital and an adequate level of reserves increase the ability to absorb unexpected and expected losses, while stable balance sheet liquidity increases the ability to absorb source shocks.…”

Factors affecting non-performing loans in commercial banks of selected West African countries

“…Bank-specific factors and macro-economic factors are the two issues concerning NPLs or credit risk. The credit risk theory of the capital market has both an idiosyncratic and a systemic aspect (Novales & Chamizo, 2019). However, only a few macro-economic variables are necessary to justify the systemic risk of any risk associated with a loan contract (Battiston & Martinez-Jaramillo, 2018).…”