Credit risk enhancement in a network of interdependent firms

We generalize existing structural models for credit risk to capture the impact of counterparty defaults on economic capital allocated to banks’ loan portfolios. Exploring the analogy to a lattice gas model from physics, correlations between sequential defaults are modeled as due to functionally defined, heterogeneous couplings between mutually dependent counterparties. We show that—already for moderate micro-economic dependencies—counterparty risk results in a fattening of the tails in the portfolio loss distribution. In particular, for stronger mutually supportive relationship between the firms, collective phenomena such as bursts and avalanches of defaults can be observed in the model. In this context, traditional credit risk models are inadequate because they underestimate the required capital buffer. Our model setting is particularly applicable for doing stress analyses of credit risk in loan portfolios.