New Economics Papers
on Banking
Issue of 2010‒06‒11
23 papers chosen by
Christian Calmès, Université du Québec en Outaouais

  1. The Credit Ratings Game By Patrick Bolton; Xavier Freixas; Joel Shapiro
  2. A Loan Portfolio Model Subject to Random Liabilities and Systemic Jump Risk By Luis H. R. Alvarez; Jani Sainio
  3. "Is Reregulation of the Financial System an Oxymoron?" By Jan Kregel
  4. MBS ratings and the mortgage credit boom By Adam Ashcraft; Paul Goldsmith-Pinkham; James Vickery
  5. "Is This the Minsky Moment for Reform of Financial Regulation?" By Jan Kregel
  6. An economic capital model integrating credit and interest rate risk in the banking book By Alessandri, Piergiorgio; Drehmann, Mathias
  7. Improving Service Performance in Banking using Quality Adjusted Data Envelopment Analysis By Juraj Kopecsni
  8. E-Business and on line banking in Bangladesh: an Analysis By Muhammad Mahboob Ali
  9. Cross-border banking and the international transmission of financial distress during the crisis of 2007-2008 By Alexander Popov; Gregory F. Udell
  10. Foreign Banks and Credit Volatility: The Case of Latin American Countries By Haouat, Meriem; Moccero, Diego Nicolas; Sosa Navarro , Ramiro
  11. Banking sector output measurement in the Euro area - a modified approach By Antonio Colangelo; Robert Inklaar
  12. Systemic risk in a network model of interbank markets with central bank activity By Co-Pierre Georg; Jenny Poschmann
  13. The impact of mergers and acquisitions on the performance of Greek Banking Sector By Panagiotis Liargovas; Spyridon Repousis
  14. Design of contingent capital with a stock price trigger for mandatory conversion By Suresh Sundaresan; Zhenyu Wang
  15. Bank secrecy, illicit money and offshore financial centers By PICARD, Pierre; PIERETTI, Patrice
  16. EU Banks Rating Assignments: Is there Heterogeneity between New and Old Member Countries? By Guglielmo Maria Caporale; Roman Matousek; Chris Stewart
  17. Foreign Bank Presence and its Effect on Firm Entry and Exit in Transition Economies By Olena Havrylchyk
  18. Liquidity-saving mechanisms in collateral-based RTGS payment systems By Jurgilas, Marius; Martin, Antoine
  19. "Too Big to Fail in Financial Crisis: Motives, Countermeasures, and Prospects" By Bernard Shull
  20. Loan availability and investment: Can innovative companies better cope with loan denials? By Mueller, Elisabeth; Reize, Frank
  21. Small Business Credit Scoring: Evidence from Japan By HASUMI Ryo; HIRATA Hideaki
  22. Asymmetric information: the multiplier effect of financial instability By Skardziukas, Domantas
  23. Multi-Factor Bottom-Up Model for Pricing Credit Derivatives By Tsui, L. K.

  1. By: Patrick Bolton; Xavier Freixas; Joel Shapiro
    Abstract: The collapse of so many AAA-rated structured finance products in 2007-2008 has brought renewed attention to the causes of ratings failures and the conflicts of interest in the Credit Ratings Industry. We provide a model of competition among Credit Ratings Agencies (CRAs) in which there are three possible sources of conflicts: 1) the CRA conflict of interest of understating credit risk to attract more business; 2) the ability of issuers to purchase only the most favorable ratings; and 3) the trusting nature of some investor clienteles who may take ratings at face value. We show that when combined, these give rise to three fundamental equilibrium distortions. First, competition among CRAs can reduce market efficiency, as competition facilitates ratings shopping by issuers. Second, CRAs are more prone to inflate ratings in boom times, when there are more trusting investors, and when the risks of failure which could damage CRA reputation are lower. Third, the industry practice of tranching of structured products distorts market efficiency as its role is to deceive trusting investors. We argue that regulatory intervention requiring: i) upfront payments for rating services (before CRAs propose a rating to the issuer), ii) mandatory disclosure of any rating produced by CRAs, and iii) oversight of ratings methodology can substantially mitigate ratings inflation and promote efficiency.
    Keywords: credit rating agencies, conficts of interest, ratings shopping.
    JEL: D43 D82 G24 L15
    Date: 2010–05
  2. By: Luis H. R. Alvarez; Jani Sainio
    Abstract: We extend the Vasi\v{c}ek loan portfolio model to a setting where liabilities fluctuate randomly and asset values may be subject to systemic jump risk. We derive the probability distribution of the percentage loss of a uniform portfolio and analyze its properties. We find that the impact of liability risk is ambiguous and depends on the correlation between the continuous aggregate factor and the asset-liability ratio as well as on the default intensity. We also find that systemic jump risk has a significant impact on the upper percentiles of the loss distribution and, therefore, on both the VaR-measure as well as on the expected shortfall.
    Date: 2010–06
  3. By: Jan Kregel
    Abstract: The extension of the subprime mortgage crisis to a global financial meltdown led to calls for fundamental reregulation of the U.S. financial system. However, that reregulation has been slow in implementation and the proposals under discussion are far from fundamental. One explanation for this delay is the fact that many of the difficulties stemmed not from lack of regulation but from a failure to fully implement existing regulations. At the same time, the crisis evolved in stages, interspersed by what appeared to be the system's return to normalcy. This evolution can be defined in terms of three stages (regulation and supervision, securitization, and a run on investment banks), each stage associated with a particular failure of regulatory supervision. It thus became possible to argue at each stage that all that was necessary was the appropriate application of existing regulations, and that nothing more needed to be done. This scenario progressed until the collapse of Lehman Brothers brought about a full-scale recession and attention turned to support of the real economy and employment, leaving the need for fundamental financial regulation in the background.
    Keywords: Financial Regulation; Financial Crisis; Subprime Crisis; Mortgage Affiliate Regulation
    JEL: G21 G24 G28
    Date: 2010–02
  4. By: Adam Ashcraft; Paul Goldsmith-Pinkham; James Vickery
    Abstract: We study credit ratings on subprime and Alt-A mortgage-backed-securities (MBS) deals issued between 2001 and 2007, the period leading up to the subprime crisis. The fraction of highly rated securities in each deal is decreasing in mortgage credit risk (measured either ex ante or ex post), suggesting that ratings contain useful information for investors. However, we also find evidence of significant time variation in risk-adjusted credit ratings, including a progressive decline in standards around the MBS market peak between the start of 2005 and mid-2007. Conditional on initial ratings, we observe underperformance (high mortgage defaults and losses and large rating downgrades) among deals with observably higher risk mortgages based on a simple ex ante model and deals with a high fraction of opaque low-documentation loans. These findings hold over the entire sample period, not just for deal cohorts most affected by the crisis.
    Keywords: Credit ratings ; Mortgages ; Mortgage-backed securities ; Subprime mortgage ; Financial crises ; Financial risk management
    Date: 2010
  5. By: Jan Kregel
    Abstract: The current financial crisis has been characterized as a "Minsky" moment, and as such provides the conditions required for a reregulation of the financial system similar to that of the New Deal banking reforms of the 1930s. However, Minsky's theory was not one that dealt in moments but rather in systemic, structural changes in the operations of financial institutions. Therefore, the framework for reregulation must start with an understanding of the longer-term systemic changes that took place between the New Deal reforms and their formal repeal under the 1999 Financial Services Modernization Act. This paper attempts to identify some of those changes and their sources. In particular, it notes that the New Deal reforms were eroded by an internal process in which commercial banks that were given a monopoly position in deposit taking sought to remove those protections because unregulated banks were able to provide substitute instruments that were more efficient and unregulated but unavailable to regulated banks, since they involved securities market activities that would eventually be recognized as securitization. Regulators and the courts contributed to this process by progressively ruling that these activities were related to the regulated activities of the commercial banks, allowing them to reclaim securities market activities that had been precluded in the New Deal legislation. The 1999 Act simply made official the de facto repeal of the 1930s protections. Any attempt to provide reregulation of the system will thus require safeguards to ensure that this internal process of deregulation is not repeated.
    Keywords: Financial Regulation; Financial Crisis; Subprime Crisis; Mortgage Affiliate Regulation; Financial Legislation; Supreme Court and Financial Deregulation
    JEL: G21 G24 G28
    Date: 2010–02
  6. By: Alessandri, Piergiorgio (Bank of England); Drehmann, Mathias (Bank for International Settlements)
    Abstract: Banks often measure credit and interest rate risk separately and then add the two risk measures to determine their overall economic capital. This approach misses complex interactions between the two risks. We develop a framework where credit and interest rate risks are analysed jointly. We focus on a traditional banking book where all positions are held to maturity and subject to book value accounting. Our simulations show that interactions between risks matter, and that their implications depend on the structure of the balance sheet and on the repricing characteristics of assets and liabilities. The analysis suggests that a joint analysis of risks can deliver substantially different results relative to a piece-wise approach: risk integration is challenging but feasible and worthwhile.
    Keywords: Economic capital; risk management; credit risk; interest rate risk; asset and liability management
    JEL: C13 E47 G21
    Date: 2010–06–01
  7. By: Juraj Kopecsni (Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic)
    Abstract: The goal of this research is to describe the application of data envelopment analysis (DEA) to the performance evaluations of bank branches. Special attention is focused on how to incorporate the quality dimension into branch efficiency. DEA will apply to a set of micro-data from a Czech commercial bank branch network. In the banking sector, providing services quality is one of the key focuses. Therefore, the quality dimension should be incorporated into the DEA model. The goal of the quality adjusted DEA model is to identify best practice branches that work efficiently and at the same time provide services with high quality. This model avoids productivity-quality tradeoff, which is present by the standard DEA model. The quality of services is measured by customer service, mystery shopping and calls, client information index, retention, and client product penetration. Main determinants of efficiency and quality level are branch size and region via purchasing power.
    Keywords: quality adjusted DEA, branch performance, scale efficiency, return to scale
    JEL: C14 C44 C61 L8
    Date: 2010–06
  8. By: Muhammad Mahboob Ali (Atish Dipankar University of Science and Technology; Bangladesh)
    Abstract: E-business has created tremendous opportunity all over the globe. On line banking can act as a complementary factor of e-business. Bangladesh Bank has recently argued to introduce automated clearing house system. This pushed upward transition from the manual banking system to the on line banking system. The study has been undertaken to observe present status of the e-business and as its complementary factor on line banking system in Bangladesh. The article analyzes the data that were collected from Bangladeshi banks up to February 2010 and also used snowball sampling techniques to gather answer from the five hundred respondents’ who have already been using on line banking system on the basis of a questionnaire which was prepared for this study purpose. The study found that dealing officials of the banks are not well conversant about their desk work. Authors’ observed that the country can be benefited through successful utilization of e-business as this will help to enhance productivity, monetary gain of both producer and customer may be feasible and positive impact on raising gross domestic product. E -business especially with the help of on line banking can manage economy of Bangladesh in a better way as customer will be satisfied.
    Date: 2010–06
  9. By: Alexander Popov (European Central Bank, Financial Research Division, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Gregory F. Udell
    Abstract: We study the effect of financial distress in foreign parent banks on local SME financing in 14 central and eastern European countries during the early stages of the 2007-2008 financial crisis. We use survey data on applicant and non-applicant firms that enable us to disentangle effects driven by shocks to the banking system from recession-driven demand shocks that may vary across lenders. We find strong evidence that credit tightened in the relatively early stages of the crises caused by the following types of bank financial distress: 1) low equity ratio; 2) low Tier 1 capital ratio; and 3) losses on financial assets. We also find that foreign banks transmit to Main Street a larger portion of similar financial shocks than domestic banks. The observed decline in credit is greater among high-risk firms and firms with fewer tangible assets. JEL Classification: E44, E51, F34, G21.
    Keywords: credit crunch, financial crisis, bank lending channel, business lending.
    Date: 2010–06
  10. By: Haouat, Meriem; Moccero, Diego Nicolas; Sosa Navarro , Ramiro
    Abstract: Foreign bank presence has substantially increased in Latin America during the second half of the 1990s, which has prompted an intense debate on its banking and macroeconomic consequences. In this paper, we apply ARCH techniques to jointly estimate the impact of foreign bank presence on the level and volatility of real credit in a panel of eight Latin American countries, using quarterly data over the period 1995:1-2001:4. Results show that, together with financial development, foreign bank presence has contributed to reduce real credit volatility, improving the buffer shock function of the banking sector. This finding is consistent with the fact that foreign banks are typically well diversified institutions holding higher quality assets and having access to a broad set of liquidity sources. Keywords: foreign banks; credit volatility; Latin America; panel data; ARCH techniques
    Keywords: Foreign Banks; Credit Volatility; Latin America; Panel Data; ARCH techniques
    JEL: E51 C33 G21
    Date: 2010–03–15
  11. By: Antonio Colangelo (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Robert Inklaar (University of Groningen, PO Box 800, 9700 AV Groningen, The Netherlands.)
    Abstract: Banks do not charge explicit fees for many of the services they provide but the service payment is bundled with the offered interest rates. This output therefore has to be imputed using estimates of the opportunity cost of funds. We argue that rather than using the single short-term, low-risk interest rate as in current official statistics, reference rates should more closely match the risk characteristics of loans and deposits. For the euro area, imputed bank output is, on average, 24 to 40 percent lower than according to current methodology. This implies an average downward adjustment of euro area GDP (at current prices) between 0.16 and 0.27 percent. JEL Classification: E01, E44, O47.
    Keywords: Bank output, FISIM, risk, loan interest rates, deposit interest rates.
    Date: 2010–06
  12. By: Co-Pierre Georg (Graduate School "Global Financial Markets - Stability and Change", Friedrich-Schiller-Universität Jena); Jenny Poschmann (School of Economics and Business Administration, Friedrich-Schiller-Universität Jena)
    Abstract: The breakdown of the interbank money markets in the face of the recent financial crisis has forced central banks and governments to take extraordinary measures to sustain financial stability. In this paper we investigate which influence central bank activity has on interbank markets. In our model, banks optimize a portfolio of risky investments and riskless excess reserves according to their risk and liquidity preferences. They are linked via interbank loans and face a stochastic supply of household deposits. We then introduce a central bank into the model and show that central bank activity enhances financial stability. We model the default of a large bank and analyse the resulting contagion effects. This is compared to a common shock that hits banks who have invested in similiar assets. Our results indicate that common shocks are not subordinate to contagion effects, but are instead the greater threat to systemic stability.
    Keywords: systemic risk, interbank markets, monetary policy, contagion, common shocks
    JEL: C63 E52 E58 G21
    Date: 2010–06–01
  13. By: Panagiotis Liargovas; Spyridon Repousis
    Abstract: The Greek banking landscape has experienced substantial changes and restructuring since the mid 1990s. This paper examines the financial performance and the implications of Greek banks’ mergers and acquisitions that took place during the period 1996-2009. With the use of event study methodology, we reject the “semi-strong form” of Efficient Market Hypothesis (EMH) of the Athens Stock Exchange, possibly reflecting leakage of information. We find that ten days prior to the announcement of a merger and acquisition, shareholders receive considerable and significant positive cumulative average abnormal returns (CAARs), which are more significant in the case of cash deals compared to stock deals. Also the results show that significant positive CAARs are gained upon the announcement of horizontal and diversifying bank deals. The overall results (the weighted average of gains to the bidder and to the target bank) indicate that bank mergers and acquisitions have no impact and do not create wealth. We also examine operating performance by estimating twenty financial ratios. Findings show that operating performance does not improve, following mergers and acquisitions. There are also controversial results when comparing merged to non-merged banks. index.
    Keywords: Banks, M&As, Event Study, Operating Performance
    Date: 2010
  14. By: Suresh Sundaresan; Zhenyu Wang
    Abstract: The proposal for banks to issue contingent capital that must convert into common equity when the banks' stock price falls below a specified threshold, or "trigger," does not in general lead to a unique equilibrium in equity and contingent capital prices. Multiple or no equilibrium arises because both equity and contingent capital are claims on the assets of the issuing bank. For a security to be robust to price manipulation, it must have a unique equilibrium. For a unique equilibrium to exist, mandatory conversion cannot result in any value transfers between equity holders and contingent capital investors. The necessary condition for unique equilibrium is usually not satisfied by contingent capital with a fixed coupon rate; however, contingent capital with a floating coupon rate is shown to have a unique equilibrium if the coupon rate is set equal to the risk-free rate. This structure of contingent capital anchors its value to par throughout the time before conversion, making it implementable in practice. Although contingent capital with a unique equilibrium is robust to price manipulation, the no-value-transfer condition may preclude it from generating the desired incentives for bank managers and demand from investors.
    Keywords: Bank capital ; Bank stocks ; Equilibrium (Economics) ; Stock - Prices ; Interest rates
    Date: 2010
  15. By: PICARD, Pierre (UniversitŽ du Luxembourg, CREA, L-1511 Luxembourg; UniversitŽ catholique de Louvain, CORE, B-1348 Louvain-la-Neuve, Belgium.); PIERETTI, Patrice (UniversitŽ du Luxembourg, CREA, L-1511 Luxembourg)
    Abstract: This paper discusses the effects of pressure policies on offshore financial centers as well as their ability to enforce the compliance of those centers with anti-money laundering regulations. Offshore banks can be encouraged to comply with rigorous monitoring of an investor's identity and the origin of his/her funds when pressure creates a sufficiently high risk of reputational harm to the investor. We show that such pressure policies harm both offshore and onshore investors and can benefit both the bank industry and tax administrations. We show that social optimal pressure policies are dichotomous decisions between no pressure at all and a pressure great enough to persuade offshore banks to comply. The delegation of pressure policies to onshore tax institutions may be inefficient. Deeper financial integration fosters compliance by the offshore center.
    Keywords: money laundering, offshore banking, compliance
    JEL: F21 K42
    Date: 2010–05–01
  16. By: Guglielmo Maria Caporale; Roman Matousek; Chris Stewart
    Abstract: We model EU countries' bank ratings using financial variables and allowing for intercept and slope heterogeneity. Our aim is to assess whether "old" and "new" EU countries are rated differently and to determine whether "new" ones are assigned lower ratings, ceteris paribus, than "old" ones. We find that country-specific factors (in the form of heterogeneous intercepts) are a crucial determinant of ratings. Whilst "new" EU countries typically have lower ratings than "old" ones, after controlling for financial variables we also discover that all countries have significantly different intercepts, confirming our prior belief. This intercept heterogeneity suggests that each country's rating is assigned uniquely, after controlling for differences in financial factors, which may reflect differences in country risk and the legal and regulatory framework that banks face (such as foreclosure laws). In addition, we find that ratings may respond differently to the liquidity and operating expenses to operating income variables across countries. Typically ratings are more responsive to the former and less sensitive to the latter for "new" EU countries compared with "old" EU countries.
    Keywords: EU countries, banks, ratings, ordered probit models, index of indicator variable
    JEL: C25 C51 C52 G21
    Date: 2010
  17. By: Olena Havrylchyk
    Abstract: This study investigates the impact of foreign bank penetration in Central and Eastern Europe on firm entry. We demonstrate that the acquisition of domestic banks by foreign investors has led to reduced firm creation, smaller average size of entrants and increased firm exit in opaque industries compared to transparent ones. At the same time, the entry of greenfield foreign banks spurred firm creation and exit. Unlike previous studies, which use interchangeably the notions of opacity and size, we define opacity in terms of technological process and show that economic significance of foreign bank entry is larger for opaque industries than for industries with large shares of small firms. Our findings can be interpreted as evidence of increased credit constraints and are consistent with theories that argue that foreign bank presence exacerbates informational asymmetries.
    Keywords: Entrepreneurship; foreign bank entry; asymmetric information; credit constraints
    JEL: E51 G21 M13
    Date: 2010–06
  18. By: Jurgilas, Marius (Bank of England); Martin, Antoine (Federal Reserve Bank of New York)
    Abstract: This paper studies banks’ incentives regarding the timing of payment submissions in a collateral-based RTGS payment system and how these incentives change with the introduction of a liquidity-saving mechanism (LSM). We show that an LSM allows banks to economise on collateral while also providing incentives to submit payments earlier. This is because in our model an LSM allows payments to be matched and offset in real time without any or very minimal funds. Under a collateral-based RTGS payment system, introduction of the LSM always improves welfare. The result contrasts with earlier work, which shows that under a fee-based RTGS system, the introduction of an LSM in some circumstances may reduce welfare.
    Keywords: liquidity-saving mechanism; intraday liquidity; payments
    JEL: E42 E58 G21
    Date: 2010–06–01
  19. By: Bernard Shull
    Abstract: Regulatory forbearance and government financial support for the largest U.S. financial companies during the crisis of 2007–09 highlighted a "too big to fail" problem that has existed for decades. As in the past, effects on competition and moral hazard were seen as outweighed by the threat of failures that would undermine the financial system and the economy. As in the past, current legislative reforms promise to prevent a reoccurrence. This paper proceeds on the view that a better understanding of why too-big-to-fail policies have persisted will provide a stronger basis for developing effective reforms. After a review of experience in the United States over the last 40 years, it considers a number of possible motives. The explicit rationale of regulatory authorities has been to stem a systemic threat to the financial system and the economy resulting from interconnections and contagion, and/or to assure the continuation of financial services in particular localities or regions. It has been contended, however, that such threats have been exaggerated, and that forbearance and bailouts have been motivated by the "career interests" of regulators. Finally, it has been suggested that existing large financial firms are preserved because they serve a public interest independent of the systemic threat of failure they pose—they constitute a "national resource." Each of these motives indicates a different type of reform necessary to contain too-big-to-fail policies. They are not, however, mutually exclusive, and may all be operative simultaneously. Concerns about the stability of the financial system dominate current legislative proposals; these would strengthen supervision and regulation. Other kinds of reform, including limits on regulatory discretion, would be needed to contain "career interest" motivations. If, however, existing financial companies are viewed as serving a unique public purpose, then improved supervision and regulation would not effectively preclude bailouts should a large financial company be on the brink of failure. Nor would limits on discretion be binding. To address this motivation, a structural solution is necessary. Breakups through divestiture, perhaps encompassing specific lines of activity, would distribute the "public interest" among a larger group of companies than the handful that currently hold a disproportionate and growing concentration of financial resources. The result would be that no one company, or even a few, would appear to be irreplaceable. Neither economies of scale nor scope appear to offset the advantages of size reduction for the largest financial companies. At a minimum, bank merger policy that has, over the last several decades, facilitated their growth should be reformed so as to contain their continued absolute and relative growth. An appendix to the paper provides a review of bank merger policy and proposals for revision."
    Keywords: Too Big to Fail; Banking Policy; Antitrust; Government Policy; Regulation
    JEL: G21 G28
    Date: 2010–05
  20. By: Mueller, Elisabeth; Reize, Frank
    Abstract: This study examines the consequences of loan denials for the investment performance of small and medium-sized German enterprises. As a consequence of a loan denial, innovative companies experience a smaller drop in the share of actual to planned investment than non-innovative companies. The non-randomness of loan denials is controlled for with a selection equation employing the intensity of banking competition at the district level as an exclusion restriction. We can explain the better performance of innovative companies by their ability to increase the use of external equity financing, such as venture capital or mezzanine capital, when facing a loan denial. --
    Keywords: Investment,loan availability,innovation,private equity
    JEL: G21 G31 O32
    Date: 2010
  21. By: HASUMI Ryo; HIRATA Hideaki
    Abstract: This paper studies the Japanese credit scoring market using data on 2,000 SMEs and a small business credit scoring model widely used in the market. After constructing a model for determining a bankfs profit maximization, we find the optimum loan sizes and profit levels, and point out some lending pitfalls based on small business credit scoring. We show that solving the problems of adverse selection and window dressing are the most important things to do to increase the profitability of SBCS lending. In addition, omitted variable bias and transparency of financial statements are also important.
    Date: 2010–06
  22. By: Skardziukas, Domantas
    Abstract: Financial markets and financial intermediation are essential to well-functioning economy. They perform the role of channeling funds to parties that have value creating investment opportunities. However, asymmetric information can seriously impair the process when parties to the financial contract are not fully aware of the risks involved and, as a result, can limit their exposure to financial agreements to prevent themselves from possible losses. Increasing asymmetric information as we explain in the article has a tendency to bring a ripple effect in the financial system. This negative money multiplier then sets the stage until it severely hampers money supply, productive investment opportunities and finally aggregate economic activity. The article introduces the reader with the framework of asymmetric information developed by several authors in the last few decades and builds on the recent financial developments that pose new challenges.
    Keywords: Asymmetric information; Financial instability; Credit spread; credit crunch; derivatives; downturn; recession; crisis forecast.
    JEL: G14 G2 G38 N22 G0
    Date: 2010–03–01
  23. By: Tsui, L. K.
    Abstract: In this note we continue the study of the stress event model, a simple and intuitive dynamic model for credit risky portfolios, proposed by Duffie and Singleton (1999). The model is a bottom-up version of the multi-factor portfolio credit model proposed by Longstaff and Rajan (2008). By a novel identification of independence conditions, we are able to decompose the loss distribution into a series expansion which not only provides a clear picture of the characteristics of the loss distribution but also suggests a fast and accurate approximation for it. Our approach has three important features: (i) it is able to match the standard CDS index tranche prices and the underlying CDS spreads, (ii) the computational speed of the loss distribution is very fast, comparable to that of the Gaussian copula, (iii) the computational cost for additional factors is mild, allowing for more flexibility for calibrations and opening the possibility of studying multi-factor default dependence of a portfolio via a bottom-up approach. We demonstrate the tractability and efficiency of our approach by calibrating it to investment grade CDS index tranches.
    Keywords: credit derivatives; CDO; bottom-up approach; multi-name; intensity-based; risk and portfolio.
    JEL: C02
    Date: 2010–05–18

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