The Credit Risk of Portfolios and Correlations
So far, we have considered default risk and credit risk exposure on a single-borrower basis. Indeed, much of the banking theory literature views the personnel at banks and similar financial institutions (FIs) as credit specialists who, through monitoring and the development of long-term relationships with customers, gain a comparative advantage in lending to a specific borrower or group of borrowers.1
However, investment principles dictate that diversification reduces risk. For example, investing in a single stock will expose the investor to both market (systematic) and company-specific (unsystematic) risk, but adding other stocks into a portfolio will tend to diversify away the unsystematic component of risk, thereby reducing the investor’s risk exposure. Because of this fundamental principle of modern portfolio theory (MPT), required returns do not include a premium for unsystematic risk.
The same principle arises when investing in debt instruments that are exposed to credit risk. If one borrower’s risk of default is inversely related to another borrower’s default probability, then combining loans to both borrowers may reduce the investor’s (lender’s) overall credit risk exposure. That is, if there is negative correlation across borrower default probabilities, then a portfolio of loans may have lower risk than an individual loan, all else equal. In this chapter, we discuss the issue of portfolio diversification ...