Credit contagion and portfolio choice

Abstract

This research studies credit contagion and portfolio choice of loan portfolio for banking institutions. The research focuses on the factors affecting the credit concentration and contagion risk of loan portfolios and examines the effect of those risks on the bank's loan portfolio decision. The thesis comprises three self-contained essays. The first essay proposes a framework to analyze the concentration risk of loan portfolios by quantifying the amount of economic capital throughout the economic cycle. The study using the Bank of Thailand’s default data demonstrates that credit concentration risk is a major cause of extreme credit portfolio losses faced by commercial banks. It shows that the concentration risk factor intensifies the adverse effect on the portfolios’ losses from the three prominent macroeconomic variables, which are inflation, manufacturing production index and unemployment. The second essay proposes a framework to analyze the credit contagion of loan portfolios with a risk management perspective concerning risk capital quantification. The model parameters can be estimated from the time-series of the portfolio default rate with the simple method of moments. The model does not impose any explicit assumption about the business relationship between counterparties or capital structure of the firm. The third essay proposes a bank's balance sheet decision model to study the impact of contagion risk and the impact of loan sale market on the loan portfolio allocation. This study suggests that contagion risk creates an opportunity for the banks with the high quality of capital to increase the profit during the stress economic regime and the loan sale market enhances the shareholders' value creation.