Credit risk contagion
In a recession, company defaults increase due to both the worsening economic environment and the specific links between customers and suppliers. Banks intuitively know that customer default can cause supplier default. Duncan Martin and Chris Marrison provide analytical support for this intuition with a simple extension of the Merton portfolio model
Current approaches to credit risk modelling typically explain correlation between companies by their exposure to common macroeconomic and financial risk factors. However, this explanation must be incomplete as common sense tells us that a credit event at one company affects the solvency of related companies directly. This effect is known intuitively by risk managers and regulators, which is why
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