Journal Article

Credit risk and financial instability

RJ Herring

in Oxford Review of Economic Policy

Published on behalf of The Oxford Review of Economic Policy Ltd

Volume 15, issue 3, pages 63-79
Published in print September 1999 | ISSN: 0266-903X
Published online September 1999 | e-ISSN: 1460-2121 | DOI: http://dx.doi.org/10.1093/oxrep/15.3.63
Credit risk and financial instability

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  • Economic Development and Growth
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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.

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Subjects: Economic Development and Growth ; Public Economics ; Political Economy ; Public Policy

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