The Role of Industry, Geography and Firm Heterogeneity in Credit Risk Diversification,” working paper

In theory the potential for credit risk diversi\u85cation for banks could be substantial. Portfolios are large enough that idiosyncratic risk is diversi\u85ed away leaving exposure to systematic risk. The potential for portfolio diversi\u85cation is driven broadly by two characteristics: the degree to which systematic risk factors are correlated with each other and the degree of dependence individual rms have to the di¤erent types of risk factors. We propose a model for exploring these dimensions of credit risk diversi\u85cation: across industry sectors and across di¤erent coun-tries or regions. We \u85nd that full \u85rm-level parameter heterogeneity matters a great deal for capturing di¤erences in simulated credit loss distributions. Imposing homogeneity results in overly skewed and fat-tailed loss distributions. These di¤erences become more pronounced in the presence of systematic risk factor shocks: increased parameter heterogeneity greatly reduces shock sensitivity. Allowing for regional parameter heterogeneity seems to better approximate the loss distributions generated by the fully heterogeneous model than allowing just for industry heterogeneity. The regional model also exhibits less shock sensitivity. Key Words: Risk management, default dependence, economic interlinkages, portfolio choic