Abstract
Recent advances in modelling credit risk bring much greater discipline to the pricing of credit risk and should promote diversification by penalizing concentrations of credit risk with greater allocations of economic capital. Although these models perform well with regard to high-frequency hazards, they are ill equipped to deal with the low-frequency, high-severity events that are likely to be the most serious threat to financial stability. Cognitive biases in estimating the probability of such losses may lead to disaster myopia. In periods of benign financial conditions, disaster myopia is likely to lead to decisions regarding allocations of economic capital, the pricing of credit risk, and the range of borrowers who are deemed creditworthy, that make the financial system increasingly vulnerable to crisis. Alternative policy measures to counter disaster myopia are considered.
Jacob Safra Professor of International Banking and Diector of the Lauder Institute and Co-Director of the Wharton Financial Institutions Center. Iam gratefull to Jack Guttentag for countless hours of discussion about disaster myopia, to Nat Chatusripitak for heipful comments on an earlier draft.
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Herring, R.J. (2002). Credit Risk and Financial Instability. In: Levich, R.M., Majnoni, G., Reinhart, C.M. (eds) Ratings, Rating Agencies and the Global Financial System. The New York University Salomon Center Series on Financial Markets and Institutions, vol 9. Springer, Boston, MA. https://doi.org/10.1007/978-1-4615-0999-8_21
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