Business cycle effects on Portfolio Credit Risk: scenario generation through Dynamic Factor analysis

In this paper, we focus on measuring the risk associated to a bank loan portfolio. In particular, we depart from the standard one factor model representation of portfolio credit risk. In particular, we consider an hetrogeneous portfolio, and we account for stochastic dependent recoveries. We also examine the influence of either one systemic shock (interpreted as the state of the business cycle) or two systemic shocks (interpreted as demand and supply innovations) on portfolio credit risk. The identification and estimation of the common shocks is obtained by fitting a Dynamic Factor model to a large number of macro credit drivers. The scenarios are obtained by employing Montecarlo stochastic simulation.