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CORRELATION AND CONTAGION IN EMPIRICAL FACTOR MODELS OF BANK CREDIT RISK
Michael Beenstock Department of Economics Hebrew University of Jerusalem
Mahmood Khatib School of Management Tel Aviv University
January 3, 2012
Credit risk may be correlated because the observed and unobserved drivers of credit risk happen to be correlated, or because they are related through contagion. We identify contagion by assuming that contagion takes time. Bank credit risk is measured by the proportion of problem loans in sectors of Israel’s banking system. Dynamic factor models are estimated for seven main sectors in which contagion is hypothesized to take place between sectors. The risk factors identified include sector-specific as well as systemic variables. Credit risk is correlated both statically and dynamically between sectors due to contagion, common risk factors, and correlated risk factors. The estimated model is used to simulate these phenomena.