nep-rmg New Economics Papers
on Risk Management
Issue of 2009‒08‒16
eight papers chosen by
Stan Miles
Thompson Rivers University

  1. Treatment of Double Default Effects within the Granularity Adjustment for Basel II By Sebastian Ebert; Eva Lütkebohmert
  2. The responsive approach by the Basel Committee (on Banking Supervision) to regulation: Meta risk regulation, the Internal Ratings Based Approaches and the Advanced Measurement Approaches. By Ojo, Marianne
  3. Estimation of tail thickness parameters from GJR-GARCH models By Emma M. Iglesias; Oliver Linton
  4. Subnational credit ratings : a comparative review By Liu, Lili; Tan, Kim Song
  6. An assessment of financial sector rescue programmes By Fabio Panetta; Thomas Faeh; Giuseppe Grande; Corrinne Ho; Michael King; Aviram Levy; Federico M. Signoretti; Marco Taboga; Andrea Zaghini
  7. Bank risk and monetary policy By Yener Altunbas; Leonardo Gambacorta; David Marques-Ibanez
  8. The Shape and Term Structure of the Index Option Smirk: Why Multifactor Stochastic Volatility Models Work so Well By Peter Christoffersen; Steven Heston; Kris Jacobs

  1. By: Sebastian Ebert; Eva Lütkebohmert
    Abstract: Within the Internal Ratings-Based (IRB) approach of Basel II it is assumed that idiosyncratic risk has been fully diversi?ed away. The impact of undiversi?ed idiosyncratic risk on portfolio Value-at-Risk can be quanti?ed via a granularity adjustment (GA). We provide an analytic formula for the GA in an extended single- factor CreditRisk+ setting incorporating double default e?ects. It accounts for guarantees and their e?ect of reducing credit risk in the portfolio. Our general GA very well suits for application under Pillar 2 of Basel II as the data inputs are drawn from quantities already required for the calculation of IRB capital charges.
    Keywords: analytic approximation, Basel II, counterparty risk, double default, granularity adjustment, IRB approach, securitization
    JEL: G31 G28
    Date: 2009–07
  2. By: Ojo, Marianne
    Abstract: The use of complex and sophisticated financial instruments, such as derivatives, in the modern financial environment, has triggered the emergence of new forms of risks. As well as the need to manage such types of risks, this paper investigates developments which have instigated the Basel Committee in developing advanced risk management techniques such as the Internal Ratings Based (IRB) approaches and the Advanced Measurement Approaches (AMA). Developments since the inception of the 1988 Basel Capital Accord have not only led to growing realisation that new forms of risks have emerged, but that previously existing and managed forms require further redress. Basel II has evolved to a form of meta regulation – a type of regulation which involves the risk management of internal risk within firms. This paper attempts to illustrate the extent to which the Basel II Capital Accord has responded to global and financial developments and concludes on the basis of available research evidence, that given the difficulties attributed to the constantly evolving nature of risk and the need for regulators to remain one step ahead, that Basel II, to an extent, has been responsive in meeting with regulatory demands. However, the existence of unregulated instruments such as hedge funds still implies that, despite its advancements and achievements, the Basel Committee still faces uphill challenges in its efforts to address and regulate risks.
    Keywords: Basel; Committee; bank; regulation; AMA; IRB; risk
    JEL: K2
    Date: 2009–08
  3. By: Emma M. Iglesias; Oliver Linton
    Abstract: We propose a method of estimating the Pareto tail thickness parameter of the unconditional distribution of a financial time series by exploiting the implications of a GJR-GARCH volatility model. The method is based on some recent work on the extremes of GARCH-type processes and extends the method proposed by Berkes, Horváth and Kokoszka (2003). We show that the estimator of tail thickness is consistent and converges at rate ?T to a normal distribution (where T is the sample size), provided the model for conditional variance is correctly specified as a GJR-GARCH. This is much faster than the convergence rate of the Hill estimator, since that procedure only uses a vanishing fraction of the sample. We also develop new specification tests based on this method and propose new alternative estimates of unconditional value at risk. We show in Monte Carlo simulations the advantages of our procedure in finite samples; and finally an application concludes the paper
    Keywords: Pareto tail thickness parameter, GARCH-type models, Value-at-Risk, Extreme value theory, Heavy tails
    JEL: C12 C13 C22 G11 G32
    Date: 2009–06
  4. By: Liu, Lili; Tan, Kim Song
    Abstract: This paper surveys methodological issues in subnational credit ratings and highlights key challenges for developing countries. Subnational borrowing from capital markets has been on the rise owing to fiscal decentralization and demand for infrastructure investments. A prerequisite for accessing capital markets, subnational credit ratings have also emerged as a part of broader reform for fiscal sustainability. They facilitate a more transparent budgetary and financial management system. The global financial crisis makes subnational credit ratings more relevant, as they contribute to fiscal risk evaluations and fiscal adjustment. In addition to subnationals’ own credit strength, the creditworthiness of the sovereign and the intergovernmental fiscal system are among the most critical rating criteria. Implicit and contingent liabilities are integral to the rating process. Indirect debt instruments including off-balance-sheet financing create fiscal risks. The ongoing financial crisis has reinforced the rating focus on the management of liquidity, debt structure, and off-balance-sheet liabilities.
    Keywords: Debt Markets,Banks&Banking Reform,,Bankruptcy and Resolution of Financial Distress,Access to Finance
    Date: 2009–08–01
  5. By: Eva Lütkebohmert
    Abstract: We show that the saddle-point approximation method to quantify the impact of undiversi?ed idiosyncratic risk in a credit portfolio is inappropriate in the presence of double default effects. Speci?cally, we prove that there does not exist an equivalent formula to the granularity adjustment, that accounts for guarantees, in case of the extended single-factor CreditRisk+ model. Moreover, in case of the model underlying the double default treatment within the internal ratings based (IRB) approach of Basel II, the saddle-point equivalent to the GA is too complex and involved to be competitive to a standard Monte Carlo approach.
    Keywords: analytical approximation, Basel II, double default, granularity adjustment, IRB approach, saddle- point approximation
    JEL: G31 G28
    Date: 2009–08
  6. By: Fabio Panetta (Banca d'Italia); Thomas Faeh (Bank for International Settlements); Giuseppe Grande (Banca d'Italia); Corrinne Ho (Bank for International Settlements); Michael King (Bank for International Settlements); Aviram Levy (Banca d'Italia); Federico M. Signoretti (Banca d'Italia); Marco Taboga (Banca d'Italia); Andrea Zaghini (Banca d'Italia)
    Abstract: We analyse the wide array of rescue programmes adopted in several countries, following Lehman Brothers’ default in September 2008, in order to support banks and other financial institutions. We first provide an overview of the programmes, comparing their characteristics, magnitudes and participation rates across countries. We then consider the effects of the programmes on banks’ risk and valuation, looking at the behaviour of CDS premia and stock prices. We then proceed to analyse the issuance of government guaranteed bonds by banks, examining their impact on banks’ funding and highlighting undesired effects and distortions. Finally, we briefly review the recent evolution of bank lending to the private sector. We draw policy implications, in particular as regards the way of mitigating the distortions implied by such programmes and the need for an exit strategy.
    Keywords: bank asset guarantees, capital injection, banks, financial sector, financial crisis, bank consolidation, bank mergers and acquisitions, event studies, government guaranteed bonds, credit crunch, exit strategy
    JEL: E58 E65 G14 G18 G21 G28 G32 G34
    Date: 2009–07
  7. By: Yener Altunbas (University of Wales, Bangor, Gwynedd LL57 2DG, Wales, United Kingdom.); Leonardo Gambacorta (Bank for International Settlements, Monetary and Economics Department, Centralbahnplatz 2, CH-4002 Basel, Switzerland.); David Marques-Ibanez (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)
    Abstract: We find evidence of a bank lending channel for the euro area operating via bank risk. Financial innovation and the new ways to transfer credit risk have tended to diminish the informational content of standard bank balance-sheet indicators. We show that bank risk conditions, as perceived by financial market investors, need to be considered, together with the other indicators (i.e. size, liquidity and capitalization), traditionally used in the bank lending channel literature to assess a bank’s ability and willingness to supply new loans. Using a large sample of European banks, we find that banks characterized by lower expected default frequency are able to offer a larger amount of credit and to better insulate their loan supply from monetary policy changes. JEL Classification: E44, E55.
    Keywords: bank, risk, bank lending channel, monetary policy.
    Date: 2009–07
  8. By: Peter Christoffersen (McGill University and CREATES); Steven Heston (R.H. Smith School of Business, University of Maryland); Kris Jacobs (McGill University and Tilburg University)
    Abstract: State-of-the-art stochastic volatility models generate a "volatility smirk" that explains why out-of-the-money index puts have high prices relative to the Black-Scholes benchmark. These models also adequately explain how the volatility smirk moves up and down in response to changes in risk. However, the data indicate that the slope and the level of the smirk fluctuate largely independently. While single-factor stochastic volatility models can capture the slope of the smirk, they cannot explain such largely independent fluctuations in its level and slope over time. We propose to model these movements using a two-factor stochastic volatility model. Because the factors have distinct correlations with market returns, and because the weights of the factors vary over time, the model generates stochastic correlation between volatility and stock returns. Besides providing more flexible modeling of the time variation in the smirk, the model also provides more flexible modeling of the volatility term structure. Our empirical results indicate that the model improves on the benchmark Heston model by 24% in-sample and 23% out-of-sample. The better fit results from improvements in the modeling of the term structure dimension as well as the moneyness dimension.
    Keywords: Stochastic correlation, stochastic volatility, equity index options, multifactor model, persistence, affine, out-of-sample
    JEL: G12
    Date: 2009–06–17

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