Credit Risk and Macroeconomic Dynamics

models aim to generate precisely that distribution, often through simulation, so that a bank may, among other things, set the level of capital it needs to hold to withstand losses to a certain degree of confidence, i.e. a tail region in the loss distribution. Most credit portfolio models link the portfolio loss distribution to states of the world; they differ in how specifically they are linked (see Figure 1).2 However, with only one exception this linkage is to a single, unobserved systematic risk factor. The basic idea of our approach, described in detail in Pesaran, Schuermann, Treutler and Weiner (2003) hereafter PSTW is to make this linkage more concrete. We will tie a bank’s credit exposures to underlying international macroeconomic factors and thereby distinguish default (and loss) due to systematic versus idiosyncratic (or firm specific) shocks. Here we start with a simple problem: the development of a conditional loss model using only publicly traded firms. We make the probability of default, PD, a function of observable macroeconomic variables but keep loss given default, LGD, exogenous (yet random). The first step in developing such a model is to build an economic engine reflective of the environment faced by an internationally active bank. This is done in Pesaran, Schuermann and Weiner (2003) hereafter PSW using recent advances in the analysis of cointegrating systems,3 where we develop a global vector-autoregressive macroeconometric model (GVAR). Because of the integrated nature of the model, we can analyze how a shock to one specific macroeconomic variable affects other macroeconomic variables, even (and especially) across countries. The model allows for interaction amongst the different economies through three separate but interrelated channels: 1. Direct dependence of the relevant macro-factors on their region-specific foreign counterparts and their agged values; 2. Dependence of the region-specific variables on common global exogenous variables such as oil prices and possibly other variables controlling for major global political events; Credit Risk and Macroeconomic Dynamics M. Hashem Pesaran and Til Schuermann