Credit contagion and aggregate losses

Abstract

Credit contagion refers to the propagation of economic distress from one firm to another. This article proposes a reduced-form model for these contagion phenomena, assuming they are due to the local interaction of firms in a business partner network. We study aggregate credit losses on large portfolios of financial positions contracted with firms subject to credit contagion. In particular, we provide an explicit Gaussian approximation of the distribution of portfolio losses. This enables us to quantify the relation between the volatility of losses and the determinants of credit contagion. We find that contagion processes have typically a second-order effect on portfolio losses. They induce additional fluctuations of losses around their averages, whose size depends on the number of business partners of the firms.