Macro, Frailty, and Contagion Effects in Defaults : Lessons from the 2008 Credit Crisis

In the aftermath of the financial crisis, banks have been subjected to a sequence of stress tests to measure system stability. Such tests are formulated in terms of adverse economic scenarios rather than in terms of systematic default rate increases.This suggests that macroeconomic conditions fully capture default stress. However, two additional explanations can be found in the literature for the occurrence of default clusters: autonomous default rate dynamics, also known as frailty, and industry-specific effects including contagion. We develop a new methodological framework to disentangle, quantify, and test these three competing explanations. Using U.S. default data we find that observed macro and financial market factors account for only 30--60% of systematic default risk. Consequently, stress-testing frameworks that only control for observed macro conditions leave out a substantial share of systematic risk. The components not related to business-cycle dynamics (frailty) are particularly relevant before and during times of financial market turbulence. For example, we find clear systemic risk build-up over the period preceding the 2008 credit crisis