Modeling the Distribution of Credit Losses with Observable and Latent Factors

by Gabriel Jiménez of the Bank of Spain, and
Javier Mencía of the Bank of Spain

March 2007

Abstract: This paper develops a flexible and computationally efficient model to estimate the credit loss distribution of the loans in a banking system. We consider a sectorial structure, where default frequencies and the total number of loans are allowed to depend on macroeconomic conditions as well as on unobservable credit risk factors, which can capture contagion effects between sectors. In addition, we also model the distributions of the Exposure at Default and the Loss Given Default. We apply our model to the Spanish credit market, where we find that sectorial default frequencies are affected by a persistent latent factor. Finally, we also identify the potentially riskier sectors and perform stress tests.

JEL Classification: G21, E32, E37.

Keywords: Credit risk, Probability of default, Loss distribution, Stress test, Contagion.

Published in: Journal of Empirical Finance, Vol. 16, No. 2, (March 2009), pp. 235-253.

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