nep-rmg New Economics Papers
on Risk Management
Issue of 2009‒07‒11
eight papers chosen by
Stan Miles
Thompson Rivers University

  1. Back to the basics in banking ? A micro-analysis of banking system stability By Olivier De Jonghe
  2. Financial Networks, Cross Holdings, and Limited Liability By Helmut Elsinger
  3. Private Insurance Against Systemic Crises? By Gersbach, Hans
  4. Is Unlevered Firm Volatility Asymmetric? By Daouk, Hazem; Ng, David
  5. Long memory in stock market volatility and the volatility-in-mean effect: the FIEGARCH-M model By Bent Jesper Christensen; Morten Ørregaard Nielsen; Jie Zhu
  6. Conditional Skewness of Aggregate Market Returns By Charoenrook, Anchada; Daouk, Hazem
  7. Moral and Social Constraints to Strategic Default on Mortgages By Luigi Guiso; Paola Sapienza; Luigi Zingales
  8. Barriers to household risk management: evidence from India By Shawn Cole; Xavier Giné; Jeremy Tobacman; Petia Topalova; Robert Townsend; James Vickery

  1. By: Olivier De Jonghe (Ghent University; National Bank of Belgium, Research Department)
    Abstract: This paper analyzes the relationship between banks’ divergent strategies toward specialization and diversification of financial activities and their ability to withstand a banking sector crash. We first generate market-based measures of banks’ systemic risk exposures using extreme value analysis. Systemic banking risk is measured as the tail beta, which equals the probability of a sharp decline in a bank’s stock price conditional on a crash in a banking index. Subsequently, the impact of (the correlation between) interest income and the components of non-interest income on this risk measure is assessed. The heterogeneity in extreme bank risk is attributed to differences in the scope of non-traditional banking activities: non-interest generating activities increase banks’ tail beta. In addition, smaller banks and better-capitalized banks are better able to withstand extremely adverse conditions. These relationships are stronger during turbulent times compared to normal economic conditions. Overall, diversifying financial activities under one umbrella institution does not improve banking system stability, which may explain why financial conglomerates trade at a discount
    Keywords: diversification, non-interest income, financial conglomerates, banking stability, extreme value analysis, tail risk
    JEL: G12 G21 G28
    Date: 2009–06
  2. By: Helmut Elsinger (Oesterreichische Nationalbank, Economic Studies Division, P.O. Box 61, A-1010 Vienna,)
    Abstract: I discuss a network of banks which are linked with each other by financial obligations and cross holdings. Given an initial endowment the value of the obligations and the equity values of the banks are determined endogenously in a way consistent with the priority of debt and the limited liability of equity. Even though neither equity values nor debt values are necessarily unique the value of debt and equity holdings of outside investors is uniquely determined. An algorithm to calculate debt and equity values is developed.
    Keywords: Financial Network; Credit Risk; Systemic Risk.
    JEL: G21 G33
    Date: 2009–05–29
  3. By: Gersbach, Hans
    Abstract: Insurance contracts contingent on macroeconomic shocks or on average bank capital could be a way of insuring against systemic crises. With insurance, banks are recapitalized when negative events would otherwise cause a write down of capital or even bank insolvency. In a simple model we illustrate the working of these contracts and how insurance could be achieved. We identify the main pitfalls of this approach: the insurance capacity of an economy may be too limited, insurance must be mandatory, insurance does not curb excessive risk taking (unobservable or observable), the insurers may go bankrupt in crises, and managerial restrictions on a rising bank equity capital limit insurance. Finally we discuss some complementary regulatory measures to foster the effectiveness of crisis insurance. In particular, we suggest mandatory purchase of insurance contracts against systemic crises by managers of large banks.
    Keywords: automatic recapitalization; banking crises; banking regulation; financial intermediation; insurance contracts
    JEL: D41 E4 G2
    Date: 2009–06
  4. By: Daouk, Hazem; Ng, David
    Abstract: Asymmetric volatility refers to the stylized fact that stock volatility is negatively correlated to stock returns. Traditionally, this phenomenon has been explained by the financial leverage effect. This explanation has recently been challenged in favor of a risk premium based explanation. We develop a new, unlevering approach to document how well financial leverage, rather than size, beta, book-to-market, or operating leverage, explains volatility asymmetry on a firm-by-firm basis. Our results reveal that, at the firm level, financial leverage explains much of the volatility asymmetry. This result is robust to different unlevering methodologies, samples, and measurement intervals. However, we find that financial leverage does not explain index-level volatility asymmetry, which is consistent with theoretical results in Aydemir, Gallmeyer and Hollifield (2006).
    Keywords: Volatility asymmetry, Financial leverage, Financial Economics, Research Methods/ Statistical Methods, G12,
    Date: 2009–06–16
  5. By: Bent Jesper Christensen (University of Aarhus and CREATES); Morten Ørregaard Nielsen (Queen's University and CREATES); Jie Zhu (University of Aarhus and CREATES)
    Abstract: We extend the fractionally integrated exponential GARCH (FIEGARCH) model for daily stock return data with long memory in return volatility of Bollerslev and Mikkelsen (1996) by introducing a possible volatility-in-mean effect. To avoid that the long memory property of volatility carries over to returns, we consider a filtered FIEGARCH-in-mean (FIEGARCH-M) effect in the return equation. The filtering of the volatility-in-mean component thus allows the co-existence of long memory in volatility and short memory in returns. We present an application to the daily CRSP value-weighted cum-dividend stock index return series from 1926 through 2006 which documents the empirical relevance of our model. The volatility-in-mean effect is significant, and the FIEGARCH-M model outperforms the original FIEGARCH model and alternative GARCH-type specifications according to standard criteria.
    Keywords: FIEGARCH, financial leverage, GARCH, long memory, risk-return tradeoff, stock returns, volatility feedback
    JEL: C22
    Date: 2009–06
  6. By: Charoenrook, Anchada; Daouk, Hazem
    Abstract: The skewness of the conditional return distribution plays a significant role in financial theory and practice. This paper examines whether conditional skewness of daily aggregate market returns is predictable and investigates the economic mechanisms underlying this predictability. In both developed and emerging markets, there is strong evidence that lagged returns predict skewness; returns are more negatively skewed following an increase in stock prices and returns are more positively skewed following a decrease in stock prices. The empirical evidence shows that the traditional explanations such as the leverage effect, the volatility feedback effect, the stock bubble model (Blanchard and Watson, 1982), and the fluctuating uncertainty theory (Veronesi, 1999) are not driving the predictability of conditional skewness at the market level. The relation between skewness and lagged returns is more consistent with the Cao, Coval, and Hirshleifer (2002) model. Our findings have implications for future theoretical and empirical models of time-varying market return distributions, optimal asset allocation, and risk management.
    Keywords: Conditional skewness, Conditional Volatility, Predicting Skewness, Aggregate market returns, International finance, Financial Economics, Marketing, Research Methods/ Statistical Methods, G12, C1,
    Date: 2009–06–16
  7. By: Luigi Guiso; Paola Sapienza; Luigi Zingales
    Abstract: We use survey data to study American households’ propensity to default when the value of their mortgage exceeds the value of their house even if they can afford to pay their mortgage (strategic default). We find that 26% of the existing defaults are strategic. We also find that no household would default if the equity shortfall is less than 10% of the value of the house. Yet, 17% of households would default, even if they can afford to pay their mortgage, when the equity shortfall reaches 50% of the value of their house. Besides relocation costs, the most important variables in predicting strategic default are moral and social considerations. Ceteris paribus, people who consider it immoral to default are at 77% less likely to declare their intention to do so, while people who know someone who defaulted are 82% more likely to declare their intention to do so. The willingness to default increases nonlinearly with the proportion of foreclosures in the same ZIP code. That moral attitudes toward default do not change with the percentage of foreclosures is likely to derive from a contagion effect that reduces the social stigma associated with default as defaults become more common.
    JEL: D12 G18 G21 G33
    Date: 2009–07
  8. By: Shawn Cole; Xavier Giné; Jeremy Tobacman; Petia Topalova; Robert Townsend; James Vickery
    Abstract: Financial engineering offers the potential to significantly reduce the consumption fluctuations faced by individuals, households, and firms. Yet much of this potential remains unfulfilled. This paper studies the adoption of an innovative rainfall insurance product designed to compensate low-income Indian farmers in the event of insufficient rainfall during the primary monsoon season. We first document relatively low adoption of this new risk management product: Only 5-10 percent of households purchase the insurance, even though they overwhelmingly cite rainfall variability as their most significant source of risk. We then conduct a series of randomized field experiments to test theories of why product adoption is so low. Insurance purchase is sensitive to price, with an estimated extensive price elasticity of demand ranging between -.66 and -0.88. Credit constraints, identified through the provision of random liquidity shocks, are a key barrier to participation, a result also consistent with household self-reports. Several experiments find that trust plays an important role in the decision to purchase insurance. We find mixed evidence that subtle psychological manipulations affect purchases and no evidence that modest attempts at financial education change households' decisions to participate. Based on our experimental results, we suggest preliminary lessons for improving the design of household risk management contracts.
    Keywords: Households - Economic aspects ; Insurance ; Risk management
    Date: 2009

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