New Economics Papers
on Banking
Issue of 2011‒12‒13
thirty-two papers chosen by
Christian Calmès, Université du Québec en Outaouais

  1. The Relationship Between Banking Market Competition and Risk-taking: Do Size and Capitalization Matter? By Benjamin M. Tabak; Dimas M. Fazio; Daniel O. Cajueiro
  2. Banks' management of the net interest margin: Evidence from Germany By Memmel, Christoph; Schertler, Andrea
  3. Securitization and bank intermediation function By Zagonov, Maxim
  4. The effect of the interbank network structure on contagion and common shocks By Georg, Co-Pierre
  5. Asset price, asset securitization and financial stability By Liu, Luke
  6. A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk By Acharya, Viral V.; Drechsler, Itamar; Schnabl, Philipp
  7. Looking for grass-root sources of systemic risk: the case of "cheques-as-collateral" network By Michalis Vafopoulos
  8. Credit Default and Business Cycles: an empirical investigation of Brazilian retail loans By Arnildo da Silva Correa; Jaqueline Terra Moura Marins; Myrian Beatriz Eiras das Neves; Antonio Carlos Magalhães da Silva
  9. The Good, The Bad and The Impaired - A Credit Risk Model of the Irish Mortgage Market By Kelly, Robert
  10. Who Said Large Banks Don't Experience Scale Economies? Evidence from a Risk-Return-Driven Cost Function By Joseph J. Hughes; Loretta Mester
  11. The Japanese Big Bang: the effects of "free, fair and global" By Montgomery, Heather; Takahashi, Yuki
  12. Credit Constraints, Heterogeneous Firms and Loan Defaults By Jarko Fidrmuc; Pavel Ciaian; d'Artis Kancs; Jan Pokrivcak
  13. Econometric Measures of Connectedness and Systemic Risk in the Finance and Insurance Sectors By Monica Billio; Mila Getmansky; Andrew W. Lo; Loriana Pelizzon
  14. Monitoring Leverage By John Geanakoplos; Lasse H. Pedersen
  15. Monetary policy, bank size and bank lending: Evidence from Australia By Liu, Luke
  16. The Irish Mortgage Market: Stylised Facts, Negative Equity and Arrears By Kennedy, Gerard; McIndoe Calder, Tara
  17. Is M&A different during a crisis? Evidence from the European banking sector By Beltratti, Andrea; Paladino, Giovanna
  18. Securitization and moral hazard: Does security price matter? By Liu, Luke
  19. Foreign banks' entry into the Russian market: motivation, entry modes and strategies By Victor Gorshkov
  20. Multivariate Semi-Markov Process for Counterparty Credit Risk By Guglielmo D'Amico; Raimondo Manca; Giovanni Salvi
  21. Funding Valuation Adjustment: a consistent framework including CVA, DVA, collateral,netting rules and re-hypothecation By Andrea Pallavicini; Daniele Perini; Damiano Brigo
  22. Knowledgeable bankers ? the demand for research in World Bank operations By Ravallion, Martin
  23. Restructuring Counterparty Credit Risk By Claudio Albanese; Damiano Brigo; Frank Oertel
  24. A Mathematical Method for Deriving the Relative Effect of Serviceability on Default Risk By Graham Andersen; David Chisholm
  25. Is Default Risk Priced in Equity Returns? By Nielsen, Caren Yinxia Guo
  26. Credit and liquidity risks in euro area sovereign yield curves By Monfort, A.; Renne, J-P.
  27. Privacy-Preserving Methods for Sharing Financial Risk Exposures By Emmanuel A. Abbe; Amir E. Khandani; Andrew W. Lo
  28. Bank Dependence and Financial Constraints on Investment: Evidence from the corporate bond market paralysis in Japan By UCHINO Taisuke
  29. A hierarchical Archimedean copula for portfolio credit risk modelling By Puzanova, Natalia
  30. When Credit Bites Back: Leverage, Business Cycles, and Crises By Òscar Jordà; Moritz HP. Schularick; Alan M. Taylor
  31. A comparative technical, cost and profit efficiency analysis of Australian, Canadian and UK banks: Feasible efficiency improvements in the context of controllable and uncontrollable factors By Dong Xiang; Abul Shamsuddin; Andrew C Worthington
  32. The role of high frequency intra-daily data, daily range and implied volatility in multi-period Value-at-Risk forecasting By Louzis, Dimitrios P.; Xanthopoulos-Sisinis, Spyros; Refenes, Apostolos P.

  1. By: Benjamin M. Tabak; Dimas M. Fazio; Daniel O. Cajueiro
    Abstract: This paper aims to study the effect of banking competition on Latin American banks' risk-taking and whether capitalization and size changes this relationship. We conclude that: (1) competition affects risk in a non-linear manner: high/low (average) competition are related to more (less) stability; (2) bank's size explains the advantage from competition, while capitalization is only positive for larger banks in this case; (3) capital ratio explains the advantage from lower competition. These results are of uttermost importance for bank regulation, especially due to the recent turmoil in worldwide financial markets.
    Date: 2011–11
  2. By: Memmel, Christoph; Schertler, Andrea
    Abstract: We decompose the change in banks' net interest margin into a change in market-wide bank rates and a change in the balance-sheet composition. Our empirical findings from a detailed data set on German banks' balance-sheet positions, broken down into different maturities, creditors and borrowers and degrees of liquidity are as follows: (i) Changes in bank rates have a much greater impact on and explain more of the variation in net interest margins than do changes in balance-sheet compositions. (ii) Changes in bank rates and changes in balance-sheet compositions affect the change in the net interest margin less strongly for derivative users than for non-users. On average, banks employ interest rate derivatives to reduce on-balance risk. (iii) When risk-taking becomes more lucrative, banks tend to increase their on-balance exposure. This effect is more pronounced for derivative users than for non-users. --
    Keywords: net interest margin,banking,balance-sheet composition
    JEL: G21
    Date: 2011
  3. By: Zagonov, Maxim
    Abstract: The move from the originate-to-hold to originate-to-distribute model of lending profoundly transformed the functioning of credit markets and weakened the natural asset transformation function performed by financial intermediaries for centuries. This shift also compromised the role of banks in channeling monetary policy initiatives, and undermined the importance of traditional asset-liability practices of interest rate risk management. The question is, therefore, whether securitisation is conducive to the optimal hedging of bank interest rate risk. The empirical results reported in this work suggest that banks resorting to securitisation do not, on average, achieve an unambiguous reduction in their exposure to the term structure fluctuations. Against this background, banks with very high involvement in the originate-to-distribute market enjoy lower interest rate risk. This however by no means implies superior risk management practices in these institutions but is merely a result of disintermediation.
    Keywords: Banks; Interest rate risk; Securitization
    JEL: C23 E52 G28 G21
    Date: 2011–09
  4. By: Georg, Co-Pierre
    Abstract: This paper proposes a dynamic multi-agent model of a banking system with central bank. Banks optimize a portfolio of risky investments and riskless excess reserves according to their risk, return, and liquidity preferences. They are linked via interbank loans and face stochastic deposit supply. Evidence is provided that the central bank stabilizes interbank markets in the short-run only. Comparing different interbank network structures, it is shown that money-center networks are more stable than random networks. Systemic risk via contagion is compared to common shocks and it is shown that both forms of systemic risk require different optimal policy responses. --
    Keywords: systemic risk,contagion,common shocks,multi-agent simulations
    JEL: C63 E52 G01 G21
    Date: 2011
  5. By: Liu, Luke
    Abstract: Prior to the Global Financial Crisis in 2008, securitization has been widely perceived as a way to disperse credit risks, and to enhance financial system’s capacity in dealing with defaults. This paper develops a model of securitization and financial stability in the form of amplification effects. This model has illustrated three different scenarios: A negative shock in the economy will lead to downturn of the economy and falling of the asset prices, deteriorating balance sheets and tightening financing conditions. However, if there is no shock or a positive shock, banks can improve its profitability significantly through securitization. While securitization decreases the probability of systemic crisis, banks tend to suffer more when the crisis happens as a result of over-borrowing and over-investing. This paper uses a three-period theoretical model to demonstrate the impact of securitization on the financial stability, and provides clear analytical guidelines for a new regulatory framework of securitization that account for systemic risk and systemic externalities.
    Keywords: Asset Price; Asset Securitization; Systemic Risk; Financial Stability
    JEL: E0 C02 G21 P34
    Date: 2011–07–09
  6. By: Acharya, Viral V.; Drechsler, Itamar; Schnabl, Philipp
    Abstract: We show that financial sector bailouts and sovereign credit risk are intimately linked. A bailout benefits the economy by ameliorating the under-investment problem of the financial sector. However, increasing taxation of the non-financial sector to fund the bailout may be inefficient since it weakens its incentive to invest, decreasing growth. Instead, the sovereign may choose to fund the bailout by diluting existing government bondholders, resulting in a deterioration of the sovereign's creditworthiness. This deterioration feeds back to the financial sector, reducing the value of its guarantees and existing bond holdings as well as increasing its sensitivity to future sovereign shocks. We provide empirical evidence for this two-way feedback between financial and sovereign credit risk using data on the credit default swaps (CDS) of the Eurozone countries and their banks for 2007-11. We show that the announcement of financial sector bailouts was associated with an immediate, unprecedented widening of sovereign CDS spreads and narrowing of bank CDS spreads; however, post-bailouts there emerged a significant co-movement between bank CDS and sovereign CDS, even after controlling for banks' equity performance, the latter being consistent with an effect of the quality of sovereign guarantees on bank credit risk.
    Keywords: credit default swaps; deleveraging; financial crises; forbearance; growth; sovereign debt
    JEL: D62 E58 G21 G28 G38
    Date: 2011–12
  7. By: Michalis Vafopoulos
    Abstract: The global financial system has become highly connected and complex. Has been proven in practice that existing models, measures and reports of financial risk fail to capture some important systemic dimensions. Only lately, advisory boards have been established in high level and regulations are directly targeted to systemic risk. In the same direction, a growing number of researchers employ network analysis to model systemic risk in financial networks. Current approaches are concentrated on interbank payment network flows in national and international level. This work builds on existing approaches to account for systemic risk assessment in micro level. Particularly, we introduce the analysis of intra-bank financial risk interconnections, by examining the real case of "cheques-as-collateral" network for a major Greek bank. Our model offers useful information about the negative spillovers of disruption to a financial entity in a bank's lending network and could complement existing credit scoring models that account only for idiosyncratic customer's financial profile. Most importantly, the proposed methodology can be employed in many segments of the entire financial system, providing a useful tool in the hands of regulatory authorities in assessing more accurate estimates of systemic risk.
    Date: 2011–12
  8. By: Arnildo da Silva Correa; Jaqueline Terra Moura Marins; Myrian Beatriz Eiras das Neves; Antonio Carlos Magalhães da Silva
    Abstract: We use microdata from the Credit Information System (SCR) of the Central Bank of Brazil to study the relationship between credit default and business cycles. In particular, we study the first part of the argument underlying the discussion about procyclicality related to the Basel II Accord: that recessions might increase credit defaults and have adverse impacts on the losses in portfolios of lender institutions. We explore both time series and cross-sectional variation in the data. Our data on the individual level are composed of retail loan transactions in two modalities—Consumer Credit and Vehicle Financing—from 2003 to 2008. Our results support the idea of a negative relationship between business cycles and credit default, but less strong than suggested in previous studies that use corporate data. We also find low and dispersed default correlations, and smaller losses in Value at Risk (VaR) experiments than those found in the literature. These results may be possibly explained by the fact that, in the retail sector, loans are given to a large number of individuals, which may help to diversify risks.
    Date: 2011–11
  9. By: Kelly, Robert (Central Bank of Ireland)
    Abstract: Using a uniquely constructed loan-level dataset of the residential mortgage book of Irish financial institutions, this paper provides a framework for estimating default probabilities of individual mortgages. In particular, the paper examines the progression of mortgages in arrears from 90 days to 360 days. This question is of major financial stability concern in an Irish context as the uncertainty concerning the quality of the loan books of the Irish financial institutions is due, in the main, to the perceived impaired nature of the residential mortgage book. Using this approach, default probabilities are shown to be “hump shaped” when conditioned on loan vintage, with loans originating between 2004 and 2006 are most likely to default.
    Keywords: Probability of Default, Mortgages, Irish Banking System
    JEL: G01 G12 G21
    Date: 2011–11
  10. By: Joseph J. Hughes (Rutgers University); Loretta Mester (Federal Reserve Bank of Philadelphia)
    Abstract: Earlier studies found little evidence of scale economies at large banks; later studies using data from the 1990s uncovered such evidence, providing a rationale for very large banks seen worldwide. Using more recent data, we estimate scale economies using two production models. The standard risk-neutral model finds little evidence of scale economies. The model using more general risk preferences and endogenous risk-taking finds large scale economies. We show that these economies are not driven by too-big-to-fail considerations. We evaluate the cost implications of breaking up the largest banks into banks of smaller size.
    Keywords: banking, production
    JEL: D21 D20
    Date: 2011–08–02
  11. By: Montgomery, Heather; Takahashi, Yuki
    Abstract: The Japanese “Big Bang” financial deregulations started in 1996. The objective was to make the Japanese banking sector more “free, fair and global”, spurring competition and resulting in a more profitable and efficient financial sector. The Big Bang brought about a massive consolidation of Japan’s already relatively concentrated banking sector. Japan’s “Top 20” banks have now merged to just three financial conglomerates that are among the largest in the world. Is this a sign of the success? Focusing on the Big Bang’s stated objectives of promoting profitability and efficiency, this study examines the Japanese “Big Bang” deregulation from its start in 1996 to completion in 2001, and the following eight years. On profitability, we find that the banking sector as a whole did not become more profitable than the pre-deregulation period. Rather, we see a steady decline in profitability. In addition, the main targets of the deregulation (and the most active in mergers and acquisitions activity during our sample period), the city, trust and long-term credit banks, actually exhibit lower profitability measured in ROA and ROE than the smaller regional banks. The “Big Bang” did not succeed in promoting a more profitable banking sector. We next turn to efficiency. We find that in terms of cost reduction, the banking sector did become more efficient after the Big Bang deregulation. However, the real bottom line of performance, profit efficiency, declined. In addition, we again see a significant difference between the big city, trust long-term credit banks and the smaller regional banks. The biggest banks are statistically significantly less profit efficient, despite their higher cost efficiency. Thus, on the whole, the Japanese “Big Bang” financial deregulation was not successful in achieving its stated objectives. Both profitability and efficiency declines on the whole, and the main targets of the deregulation, the big city, trust and long-term credit banks, exhibit statistically significantly lower profitability and efficiency than their smaller counterparts.
    Keywords: deregulation; profitability; efficiency
    JEL: G28 G21
    Date: 2011–09
  12. By: Jarko Fidrmuc; Pavel Ciaian; d'Artis Kancs; Jan Pokrivcak
    Abstract: In light of the recent financial and economic crisis the present paper analyzes the determinants of loan default. We employ a unique firm-level panel data of 700 bank loans given to small and medium sized enterprises in Slovakia between 2000 and 2005 to investigate three loan default hypothesis. Testing the Sector-Risk Hypothesis, we find that agro-food industry does not exhibit higher default rate than other sectors. Testing the Firm-Risk Hypothesis, we find that highly indebted firms are more likely to default on their loan than other firms. Testing the EU Subsidy Hypothesis we find that the newly introduced subsidy system, which is decoupled from production, provides a secure source of income and hence reduces the probability of loan default.
    Keywords: Bank credit, loan default, credit constraints, heterogeneous firms.
    JEL: G33 G21 C25 Q14
    Date: 2011–11–17
  13. By: Monica Billio (Department of Economics, University Ca’ Foscari of Venice); Mila Getmansky (Isenberg School of Management, University of Massachusetts); Andrew W. Lo (MIT Sloan School of Management); Loriana Pelizzon (Department of Economics, University Ca’ Foscari of Venice)
    Abstract: We propose several econometric measures of connectedness based on principal-components analysis and Granger-causality networks, and apply them to the monthly returns of hedge funds, banks, broker/dealers, and insurance companies. We find that all four sectors have become highly interrelated over the past decade, likely increasing the level of systemic risk in the finance and insurance industries through a complex and time-varying network of relationships. These measures can also identify and quantify financial crisis periods, and seem to contain predictive power in out-of-sample tests. Our results show an asymmetry in the degree of connectedness among the four sectors, with banks playing a much more important role in transmitting shocks than other financial institutions.
    Keywords: Systemic Risk; Financial Institutions; Liquidity; Financial Crises
    JEL: G12 G29 C51
    Date: 2011
  14. By: John Geanakoplos (Cowles Foundation, Yale University); Lasse H. Pedersen (Stern School of Business, NYU)
    Abstract: We discuss how leverage can be monitored for institutions, individuals, and assets. While traditionally the interest rate has been regarded as the important feature of a loan, we argue that leverage is sometimes even more important. Monitoring leverage provides information about how risk builds up during booms as leverage rises and how crises start when leverage on new loans sharply declines. Leverage data is also a crucial input for crisis management and lending facilities. Leverage at the asset level can be monitored by down payments or margin requirement or and haircuts, giving a model-free measure that can be observed directly, in contrast to other measures of systemic risk that require complex estimation. Asset leverage is a fundamental measure of systemic risk and so is important in itself, but it is also the building block out of which measures of institutional leverage and household leverage can be most accurately and informatively constructed.
    Keywords: Leverage, Loan to value, Margins, Haircuts, Monitor, Regulate, Leverage on new loans, Asset leverage, Investor leverage
    JEL: D52 D53 E44 G01 G10 G12
    Date: 2011–12
  15. By: Liu, Luke
    Abstract: The transmission of monetary policy may hold the key to explaining the effects of policy on the economy. The objective of the study is to assess the importance of the bank lending channel in the transmission of monetary policy in Australia. In this paper, we found that the effectiveness of monetary policy varies with the size of the bank as well as the type of the loan. For different asset size and different kinds of loans, the effect of monetary policy is different. Thus, policy has distributional effects on bank loans that depend on asset size and industry in the economy.
    Keywords: Monetary policy; Bank lending; Bank size
    JEL: C23 E52 C01
    Date: 2011–06–26
  16. By: Kennedy, Gerard (Central Bank of Ireland); McIndoe Calder, Tara (Central Bank of Ireland)
    Abstract: This paper uses loan-level data from the residential mortgage books of four Irish credit institutions, as at December 2010. The focus of the paper, is to provide an overview of the structure and condition of these housing loan books. This includes a description of borrower categories, interest rate profiles, repayment structures, property types, arrears accruals and the regional distributions of these loan and borrower characteristics across Ireland. Because it is possible to secure more than one loan on an individual house, we distinguish the number of properties underlying the residential mortgage book. Additionally we combine the data with house price data in order to generate estimates on the amount of housing equity in the Irish mortgage market. We focus on the properties in negative equity, in particular. Our findings suggest that approximately 31 per cent of mortgaged properties, representing over 47 per cent of the mortgage books’ outstanding loan balances were in negative equity at the end of 2010. Of the mortgaged properties in negative equity, 8 per cent had also accrued more than three months worth of arrears on their mortgage loans.
    Keywords: Credit, Asset Pricing, Banks, Mortgages, Regional Economic Activity, Size and Spatial Distributions of Regional Economic Activity, Housing Demand, Housing Supply and Markets
    JEL: G01 G12 G21 R11 R12 R21 R31
    Date: 2011–11
  17. By: Beltratti, Andrea; Paladino, Giovanna
    Abstract: The financial crisis has affected the landscape of the banking sector around the world. We use a sample of transactions taking place in Europe in 2007-2010 to study the acquirer’s stock price market reaction to announcements and completions of acquisitions. We find that there are no significant abnormal returns around the announcement of an acquisition while there are positive abnormal returns at completions. We study the cross-sectional determinants of abnormal returns and find that announcement returns are mainly explained by the acquirer bank characteristics, while completion returns depend on opacity of the target and in large part on the drop in volatility associated with a reduction of uncertainty.
    Keywords: Mergers and Acquisitions; Banks; Opacity; Financial crisis
    JEL: G34 G21
    Date: 2011–11–25
  18. By: Liu, Luke
    Abstract: This article analyses the effect of security price on the behaviour of bank securitization. We present a model of bank securitization in which security price together with liquid constraints create the incentive for banks to originate and sell assets backed securities to investors. Banks have a comparative advantage in locating and screening projects within their locality. Our results show that under the buyer’s market pricing mechanism the banks with different liquidity constraints can share the risk and the moral hazard problem is not serious; but under the seller’s market pricing mechanism the banks have the incentive to conduct strategic securitization and the moral hazard problem is serious. Our main idea has been supported by the subprime crisis broke in the US in 2007.
    Keywords: Securitization; Security price; Moral hazard
    JEL: C50 C02 G21
    Date: 2011–05–19
  19. By: Victor Gorshkov (PhD student, Graduate School of Economics, Kyoto University)
    Abstract: The present paper analyses motivation, entry modes and strategies of foreign banks entering into the Russian market. The share of foreign assets in the banking sector is gradually increasing, proving the fact that more and more foreign banks show their interest in the Russian banking sector. What lies behind this growth? The article shows that motivation for entry is similar to some other developing and transition economies (both PUSH and PULL reasons exist) and presents some peculiar features concerning the modes of entry and strategies. It is shown that recently organic strategy growth is gradually replaced by M&A.
    Keywords: foreign banks, motivation, entry modes, strategies, M&A
    Date: 2011–12
  20. By: Guglielmo D'Amico; Raimondo Manca; Giovanni Salvi
    Abstract: In this work we define a multivariate semi-Markov process. We derive an explicit expression for the transition probability of this multivariate semi-Markov process in the discrete time case. We apply this multivariate model to the study of the counterparty credit risk, with regard to correlation in a CDS contract. The financial crisis has stressed the importance of the study of the correlation in the financial market. In this regard, the study of the risk of default of the counterparty in any financial contract has become crucial in the credit risk. Many works has been done to trying to describe the counterparty risk in a CDS contract, but all this work are based on the Markovian approach to risk. In the our opinion this kind of model are too restrictive, because they require that the distribuction function of the waiting times has to be exponential or geometric, for discrete time. In the our model, we describe the evolution of credit rating of the financial subjects like a multivariate semi-Markov model, so we allow for arbitrarily distributed sojourn time. The age state dependency, typical of the semi-Markov environment, allow us to insert the correlation in a dynamical way. In particular, suppose that A is a default-free bondholder and C is the relative firm. The bondholder buy protection against C's default by another defaultable subject, say B the protection seller. Our model describe the evolution of the credit rating of the couple B and C. We admit for simultaneus default of C and B, the single default of C or single default of B.
    Date: 2011–12
  21. By: Andrea Pallavicini; Daniele Perini; Damiano Brigo
    Abstract: In this paper we describe how to include funding and margining costs into a risk-neutral pricing framework for counterparty credit risk. We consider realistic settings and we include in our models the common market practices suggested by the ISDA documentation without assuming restrictive constraints on margining procedures and close-out netting rules. In particular, we allow for asymmetric collateral and funding rates, and exogenous liquidity policies and hedging strategies. Re-hypothecation liquidity risk and close-out amount evaluation issues are also covered. We define a comprehensive pricing framework which allows us to derive earlier results funding or counterparty risk. Some relevant examples illustrate the non trivial settings needed to derive known facts about discounting curves by starting from a general framework and without resorting to ad hoc hypotheses. Our main result is a bilateral collateralized counterparty valuation adjusted pricing equation, which allows to price a deal while taking into account credit and debt valuation adjustments along with margining and funding costs in a coherent way. We find that the equation has a recursive form, making the introduction of an additive funding valuation adjustment difficult. Yet, we can cast the pricing equation into a set of iterative relationships which can be solved by means of standard least-square Monte Carlo techniques.
    Date: 2011–12
  22. By: Ravallion, Martin
    Abstract: Development impact calls for knowledgeable development practitioners. How then do the operational staff of the largest development agency value and use its research? Is there an incentive to learn and does it translate into useful knowledge? A new survey reveals that the bulk of the World Bank's senior staff value the Bank's research for their work, and most come to know it well, although a sizable minority have difficulty accessing research to serve their needs. Another group sees little value to research for their work and does not bother to find out about it. Higher perceived value is reflected in greater knowledge about research, though there are frictions in this process. Staff working on poverty, human development and economic policy tend to value and use research more than staff in the more traditional sectors of Bank lending -- agriculture and rural development, energy and mining, transport and urban development; the latter sectors account for 45 percent of lending but only 15 percent of staff highly familiar with Bank research. Without stronger incentives for learning and more relevant and accessible research products, it appears likely that this lag in demand for research by the traditional sectors will persist.
    Keywords: Agricultural Knowledge&Information Systems,Information Security&Privacy,Rural Development Knowledge&Information Systems,Banks&Banking Reform,Poverty Monitoring&Analysis
    Date: 2011–12–01
  23. By: Claudio Albanese; Damiano Brigo; Frank Oertel
    Abstract: We introduce an innovative theoretical framework for the valuation and replication of derivative transactions between defaultable entities based on the principle of arbitrage freedom. Our framework extends the traditional formulations based on Credit and Debit Valuation Adjustments (CVA and DVA). Depending on how the default contingency is accounted for, we list a total of ten different structuring styles. These include bi-partite structures between a bank and a counterparty, tri-partite structures with one margin lender in addition, quadri-partite structures with two margin lenders and, most importantly, configurations where all derivative transactions are cleared through a Central Counterparty Clearing House (CCP). We compare the various structuring styles under a number of criteria including consistency from an accounting standpoint, counterparty risk hedgeability, numerical complexity, transaction portability upon default, induced behaviour and macro-economic impact of the implied wealth allocation.
    Date: 2011–12
  24. By: Graham Andersen; David Chisholm
    Abstract: The writers propose a mathematical Method for deriving risk weights which describe how a borrower's income, relative to their debt service obligations (serviceability) affects the probability of default of the loan. The Method considers the borrower's income not simply as a known quantity at the time the loan is made, but as an uncertain quantity following a statistical distribution at some later point in the life of the loan. This allows a probability to be associated with an income level leading to default, so that the relative risk associated with different serviceability levels can be quantified. In a sense, the Method can be thought of as an extension of the Merton Model to quantities that fail to satisfy Merton's 'critical' assumptions relating to the efficient markets hypothesis. A set of numerical examples of risk weights derived using the Method suggest that serviceability may be under-represented as a risk factor in many mortgage credit risk models.
    Date: 2011–11
  25. By: Nielsen, Caren Yinxia Guo (Department of Economics, Lund University)
    Abstract: Fama and French (1992, 1993, 1995 and 1996) declare that size and book-to-market equity (BM) have strong explanatory power for the cross-section of stock returns, and the risk captured by size and BM is the relative distress of small stocks and value stocks. Firstly, this study examines the pricing power of the default risk, measured by the market revealed credit default swap premiums for individual U.S. firms from 2004 to 2010, in average returns across stocks; secondly, it explores whether the size and BM effects are due to that they proxy for the default risk effect. The tests demonstrate that size effect dominates the joint effect of size and default risk, while both BM and default risk co-work for the joint effect of BM and default risk. Therefore, part of the size and BM effects can be interpreted as default risk effect. As expected, size is priced with a negative risk premium, and BM is priced with a positive risk premium. However, higher default risk is priced with higher expected stock returns only when BM is below a certain level and BM is not priced. Additionally, size indeed proxies for the sensitivity to the default risk factor. Furthermore, the Fama-French factors SMB (small-minus-big) and HML (high-minus-low), mimicking the risks related to size and BM, share some common information with the default risk factor in the asset pricing tests.
    Keywords: Asset Pricing; Equity Returns; Size Effect; Book-to-Market Effect; Default Risk Effect; Credit Default Swap Premium
    JEL: G12
    Date: 2011–11–04
  26. By: Monfort, A.; Renne, J-P.
    Abstract: In this paper, we propose a model of the joint dynamics of euro-area sovereign yield curves. The arbitrage-free valuation framework involves five factors and two regimes, one of the latter being interpreted as a crisis regime. These common factors and regimes explain most of the fluctuations in euro-area yields and spreads. The regime-switching feature of the model turns out to be particularly relevant to capture the rise in volatility experienced by fixed-income markets over the last years. In our reduced-form set up, each country is characterized by a hazard rate, specified as some linear combinations of the factors and regimes. The hazard rates incorporate both liquidity and credit components, that we aim at disentangling. The estimation suggests that a substantial share of the changes in euro-area yield differentials is liquidity-driven. Our approach is consistent with the fact that sovereign default risk is not diversifiable, which gives rise to specific risk premia that are incorporated in spreads. Once liquidity-pricing effects and risk premia are filtered out of the spreads, we obtain estimates of the actual –or real-world– default probabilities. The latter turn out to be significantly lower than their risk-neutral counterparts.
    Keywords: default risk, liquidity risk, term structure of interest rates, regime-switching, euro-area spreads.
    JEL: E43 E44 E47 G12 G24
    Date: 2011
  27. By: Emmanuel A. Abbe; Amir E. Khandani; Andrew W. Lo
    Abstract: Unlike other industries in which intellectual property is patentable, the financial industry relies on trade secrecy to protect its business processes and methods, which can obscure critical financial risk exposures from regulators and the public. We develop methods for sharing and aggregating such risk exposures that protect the privacy of all parties involved and without the need for a trusted third party. Our approach employs secure multi-party computation techniques from cryptography in which multiple parties are able to compute joint functions without revealing their individual inputs. In our framework, individual financial institutions evaluate a protocol on their proprietary data which cannot be inverted, leading to secure computations of real-valued statistics such a concentration indexes, pairwise correlations, and other single- and multi-point statistics. The proposed protocols are computationally tractable on realistic sample sizes. Potential financial applications include: the construction of privacy-preserving real-time indexes of bank capital and leverage ratios; the monitoring of delegated portfolio investments; financial audits; and the publication of new indexes of proprietary trading strategies.
    Date: 2011–11
  28. By: UCHINO Taisuke
    Abstract: This paper investigates the causal relationship between firms' bank dependence and financial constraints by utilizing the 2008 financial crisis and its impact on the Japanese economy as a natural experiment. Since the Japanese banking sector remained healthy while the corporate bond markets were paralyzed, firms that had reduced bank dependence were hit heavily by the shock. I examined whether firms with large holdings of corporate bonds maturing in 2008 were financially constrained, by comparing the changes in their investment expenditures and borrowing conditions with those of bank-dependent firms. The main empirical results show that (1) firms with large holdings of corporate bonds maturing in 2008 did not cut investment expenditures; (2) instead, they observed higher increments in bank loans; and (3) firms that maintained relatively close bank-firm relationships had more access to bank loans with low borrowing costs, but significant differences in investment expenditures were not found. These findings imply that although there is a cost to reducing bank dependence, it is not very high for Japanese listed firms.
    Date: 2011–11
  29. By: Puzanova, Natalia
    Abstract: I introduce a novel, hierarchical model of tail dependent asset returns which can be particularly useful for measuring portfolio credit risk within the structural framework. To allow for a stronger dependence within sub-portfolios than between them, I utilise the concept of nested Archimedean copulas, but modify the nesting procedure to ensure the compatibility of copula generators by construction. This makes sampling straightforward. Moreover, I provide details on a particular specification based on a gamma mixture of powers. This model allows for lower tail dependence, resulting in a more conservative credit risk assessment than a comparable Gaussian model. I illustrate the extent of model risk when calculating VaR or Expected Shortfall for a credit portfolio. --
    Keywords: portfolio credit risk,nested Archimedean copula,tail dependence,hierarchical dependence structure
    JEL: C46 C63 G21
    Date: 2011
  30. By: Òscar Jordà; Moritz HP. Schularick; Alan M. Taylor
    Abstract: This paper studies the role of leverage in the business cycle. Based on a study of nearly 200 recession episodes in 14 advanced countries between 1870 and 2008, we document a new stylized fact of the modern business cycle: more credit-intensive booms tend to be followed by deeper recessions and slower recoveries. We find a close relationship between the rate of credit growth relative to GDP in the expansion phase and the severity of the subsequent recession. We use local projection methods to study how leverage impacts the behavior of key macroeconomic variables such as investment, lending, interest rates, and inflation. The effects of leverage are particularly pronounced in recessions that coincide with financial crises, but are also distinctly present in normal cycles. The stylized facts we uncover lend support to the idea that financial factors play an important role in the modern business cycle.
    JEL: C14 C52 E51 F32 F42 N10 N20
    Date: 2011–11
  31. By: Dong Xiang; Abul Shamsuddin; Andrew C Worthington
    Keywords: Stochastic frontier analysis, technical, cost and profit efficiency, banks
    JEL: C23 D24 G21
    Date: 2011
  32. By: Louzis, Dimitrios P.; Xanthopoulos-Sisinis, Spyros; Refenes, Apostolos P.
    Abstract: In this paper, we assess the informational content of daily range, realized variance, realized bipower variation, two time scale realized variance, realized range and implied volatility in daily, weekly, biweekly and monthly out-of-sample Value-at-Risk (VaR) predictions. We use the recently proposed Realized GARCH model combined with the skewed student distribution for the innovations process and a Monte Carlo simulation approach in order to produce the multi-period VaR estimates. The VaR forecasts are evaluated in terms of statistical and regulatory accuracy as well as capital efficiency. Our empirical findings, based on the S&P 500 stock index, indicate that almost all realized and implied volatility measures can produce statistically and regulatory precise VaR forecasts across forecasting horizons, with the implied volatility being especially accurate in monthly VaR forecasts. The daily range produces inferior forecasting results in terms of regulatory accuracy and Basel II compliance. However, robust realized volatility measures such as the adjusted realized range and the realized bipower variation, which are immune against microstructure noise bias and price jumps respectively, generate superior VaR estimates in terms of capital efficiency, as they minimize the opportunity cost of capital and the Basel II regulatory capital. Our results highlight the importance of robust high frequency intra-daily data based volatility estimators in a multi-step VaR forecasting context as they balance between statistical or regulatory accuracy and capital efficiency.
    Keywords: Realized GARCH; Value-at-Risk; multiple forecasting horizons; alternative volatility measures; microstructure noise; price jumps
    JEL: C53
    Date: 2012–10–29

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