The modeling and management of credit risk is the main topic within banks
and other lending institutions. Credit risk refers to the risk of losses due to
some credit event as, for example, the default of a counterparty. Thus, credit
risk is associated with the possibility that an event may lead to some negative
effects which would not generally be expected and which are unwanted. The
main difficulties, when modeling credit risk, arise from the fact that default
events are quite rare and that they occur unexpectedly. When, however, default
events take place, they often lead to significant losses, the size of which is
not known before default. Although default events occur very seldom, credit
risk is, by definition, inherent in any payment obligation. Banks and other
lending institutions usually suffer severe losses when in a short period of time
the quality of the loan portfolio deteriorates significantly. Therefore, modern
society relies on the smooth functioning of the banking and insurance systems
and has a collective interest in the stability of such systems. There exist,
however, several examples of large derivative losses like Orange County (1.7
billion US$), Metallgesellschaft (1.3 billion US$) or Barings (1 billion US$),
which took place between 1993 and 1996. These examples have increased the
demand for regulation aiming at financial stability and prove that risk management
is indeed a very important issue.
A particular form of credit risk is referred to as concentration risk. Concentration
risks in credit portfolios arise from an unequal distribution of loans to
single borrowers (name concentration) or industrial or regional sectors (sector
or country concentration). In addition, certain dependencies between different
borrowers can increase the credit risk in a portfolio since the default of one
borrower can cause the default of a dependent second borrower. This effect
is called default contagion and is linked to both name and sector concentration.