New Economics Papers
on Risk Management
Issue of 2009‒10‒10
23 papers chosen by

  1. The Systemic Regulation of Credit Rating Agencies and Rated Markets By Amadou N. R. Sy
  2. Estimating Default Frequencies and Macrofinancial Linkages in the Mexican Banking Sector By Rodolphe Blavy; Marcos Souto
  3. Optimal Central Counterparty Risk Management By Haene, Philipp; Sturm, Andy
  4. The Need for Special Resolution Regimes for Financial Institutions—The Case of theEuropean Union By Martin Cihák; Erlend Nier
  5. French Banks Amid the Global Financial Crisis By Yingbin Xiao
  6. Recent Advances in Credit Risk Modeling By Jose Giancarlo Gasha; Carlos I. Medeiros; Marcos Souto; Christian Capuano; Andre Santos; Jorge A. Chan-Lau
  7. The Federal Reserve System Balance Sheet-What Happened and Why it Matters By Peter Stella
  8. The Real Effects of Financial Sector Risk By Alexander F. Tieman; Andrea M. Maechler
  9. Modernizing Bank Regulation in Support of Financial Deepening: The Case of Uruguay By Mario Mansilla; Gustavo Adler; Torsten Wezel
  10. Capital Requirements and Business Cycles with Credit Market Imperfections By Pierre-Richard Agénor; Koray Alper; Luiz Pereira da Silva
  11. Extreme Risk and Fat-tails Distribution Model:Empirical Analysis By Onour, Ibrahim
  12. On the Behaviour and Determinants of Risk-Based Capital Ratios: Revisiting the Evidence from UK Banking Institutions By William Francis; Matthew Osborne
  13. Bank Competition, Risk and Asset Allocations By Gianni De Nicoló; John H. Boyd; Abu M. Jalal
  14. Beyond the Third Pillar of Basel Two: Taking Bond Market Signals Seriously By Adrian Pop
  15. Financial Intermediation, Competition, and Risk: A General Equilibrium Exposition By Gianni De Nicoló; Marcella Lucchetta
  16. Asymptotic behavior of the finite-time expected time-integrated negative part of some risk processes and optimal reserve allocation By Romain Biard; Stéphane Loisel; Claudio Macci; Noel Veraverbeke
  17. Credit Risk Spreads in Local and Foreign Currencies By Dan Galai; Zvi Wiener
  18. A Framework for Financial Market Development By Ralph Chami; Sunil Sharma; Connel Fullenkamp
  19. The Derivatives Market in South Africa: Lessons for sub-Saharan African Countries By Olatundun Janet Adelegan
  20. How the Financial Crisis Affects Pensions and Insurance and Why the Impacts Matter By Gregorio Impavido; Ian Tower
  21. The Effects of the Financial Crisis on Public-Private Partnerships By Maria Delgado Coelho; Philippe Burger; Justin Tyson; I. Karpowicz
  22. Options introduction and volatility in the EU ETS By Julien Chevallier; Yannick Le Pen; Benoît Sévi
  23. Out of the Box Thoughts about the International Financial Architecture By Barry J. Eichengreen

  1. By: Amadou N. R. Sy
    Abstract: Credit ratings have contributed to the current financial crisis. Proposals to regulate credit rating agencies focus on micro-prudential issues and aim at reducing conflicts of interest and increasing transparency and competition. In contrast, this paper argues that macro-prudential regulation is necessary to address the systemic risk inherent to ratings. The paper illustrates how financial markets have increasingly relied on ratings. It shows how downgrades have led to systemic market losses and increased illiquidity. The paper suggests the use of "ratings maps" and stress-tests to assess the systemic risk of ratings, and increased capital or liquidity buffers to manage such risk.
    Keywords: Bank supervision , Banking sector , Bonds , Capital markets , Credit , Credit risk , Financial crisis , Financial risk , Financial systems , Governance , Nonbank financial sector , Risk management , Securities markets , Securities regulations ,
    Date: 2009–06–19
  2. By: Rodolphe Blavy; Marcos Souto
    Abstract: The credit risk measures we develop in this paper are used to investigate macrofinancial linkages in the Mexican banking system. Domestic and external macro-financial variables are found to be closely associated with banking soundness. At the aggregate level, high external volatility and domestic interest rates are associated with higher expected default probability. Though results vary substantially across individual banks, domestic activity and U.S. growth, and higher asset prices, are generally associated with lower credit risks, while increased volatility worsens credit risks. The expected default probability is also found to be a leading indicator of traditional financial stability indicators.
    Keywords: Bank soundness , Banking sector , Banks , Credit risk , Data analysis , Economic models , Mexico ,
    Date: 2009–05–27
  3. By: Haene, Philipp (Swiss National Bank); Sturm, Andy (Swiss National Bank)
    Abstract: In order to protect themselves against the potential losses in case of a participant’s default and to contain systemic risk, central counterparties (CCPs) need to maintain sufficient financial resources. Typically, these financial resources consist of margin requirements and contributions to a collective default fund. Based on a stylized model of CCP risk management, this article analyzes the main factors affecting the trade-off between margins and default fund. The optimal balance between these two risk management instruments is found to depend on collateral costs, participants’ default probability, and the extent to which margin requirements are associated with risk-mitigating incentives. Given the increasing role of CCPs in financial markets in general and for financial stability in particular, these considerations are not only important for CCPs themselves, but also for financial regulators.
    Keywords: Central counterparty; margin requirements; default fund; financial stability; incentives
    JEL: G18 G23 G32
    Date: 2009–06–30
  4. By: Martin Cihák; Erlend Nier
    Abstract: The global financial crisis has demonstrated weaknesses in resolution regimes for financial institutions around the globe, including in the European Union (EU). This paper considers the principles underlying resolution regimes for financial institutions, and draws out how a well-designed resolution regime can expand the toolset available for crisis management. Introducing, or in some cases expanding the scope, of these regimes is pressing to achieve more effective responses to ongoing financial sector weaknesses across the EU.
    Keywords: Bank resolution , Bank supervision , Bankruptcy , Banks , Credit risk , European Union , Financial institutions , Financial risk , Financial sector , Financial stability , Nonbank financial sector , Risk management ,
    Date: 2009–09–17
  5. By: Yingbin Xiao
    Abstract: This paper runs the gamut of qualitative and quantitative analyses to examine the performance of French banks during 2006-2008 and the financial support measures taken by the French government. French banks were not immune but proved relatively resilient to the global financial crisis reflecting their business and supervision features. An event study of the impact of government measures on CDS, debt, and equity markets points to the reduction of credit risk and financing cost as well as the redistribution of resources. With the crisis still unfolding, uncertainties remain and challenges lie ahead, calling for continued vigilance and enhanced risk management.
    Keywords: Asset management , Bank restructuring , Bank soundness , Bank supervision , Banking sector , Business cycles , Corporate sector , Credit risk , Financial crisis , Financial instruments , France , Liquidity management , Profits , Risk management ,
    Date: 2009–09–17
  6. By: Jose Giancarlo Gasha; Carlos I. Medeiros; Marcos Souto; Christian Capuano; Andre Santos; Jorge A. Chan-Lau
    Abstract: As is well known, most models of credit risk have failed to measure the credit risks in the context of the global financial crisis. In this context, financial industry representatives, regulators and academics worldwide have given new impetus to efforts to improve credit risk modeling for countries, corporations, financial institutions, and financial instruments. The paper summarizes some of the recent advances in this regard. It considers modifications of structural models, including of the classical Merton model, and efforts to reconcile the structural and the reduced-form models. It also discusses the reassessment of the default correlations using copulas, the pricing of credit index options, and the determination of the prices of distressed debt and estimation of recovery values.
    Keywords: Asset prices , Bankruptcy , Bonds , Credit risk , Currencies , Economic models , External debt , Financial crisis , Financial risk , Financial sector , Sovereign debt ,
    Date: 2009–08–04
  7. By: Peter Stella
    Abstract: The recent expansion of the balance sheet of the consolidated Federal Reserve Banks (FRB) is analyzed in an historical context. The analysis reveals that the nature of Fed involvement in U.S. financial markets has changed dramatically and its expansion is several orders of magnitude beyond what is usually reported. The associated fiscal risks and potential exit strategies are then considered. Although risks are considerable in certain unlikely scenarios, FRB capital, earnings capacity, and reserves are more than ample to preserve their financial independence. Nevertheless, the occurrence of losses or a significant drop in FRB profit might lead to an eventual curtailment of Fed operational independence. The paper concludes by considering options to enhance FRB risk management and to assign responsibilities for monetary, financial stability and fiscal policies once the current crisis is overcome.
    Keywords: Capital markets , Central bank policy , Central banks , Commercial banks , Credit risk , Financial risk , Financial systems , Liquidity management , Monetary policy , Monetary reserves , Risk management , United States ,
    Date: 2009–06–01
  8. By: Alexander F. Tieman; Andrea M. Maechler
    Abstract: This paper estimates the magnitude of key effects on the real economy from financial sector stress. We focus on the short-run feedback effect from market-based indicators of financial sector risk to the real economy through the credit channel, and estimate this effect on an economy-wide (macro) level, as well as on the level of individual large banks. Both estimates yield significant feedback effects of substantial magnitude. The estimates are consistent with other work in this area. Our results suggest that prudential supervision could be enhanced by taking into account the feedback effects of financial instability in the real economy. We also propose a way to integrate feedback effects into stress tests in order to improve realism and accuracy or macroeconomic stress scenarios, as well as a metric to interpret stress testing results.
    Keywords: Banks , Credit expansion , Economic models , European Union , Financial risk , Financial sector , Financial stability ,
    Date: 2009–09–15
  9. By: Mario Mansilla; Gustavo Adler; Torsten Wezel
    Abstract: This paper studies how Uruguay's regulatory framework was gradually strengthened to address shortcomings identified during the 2002-03 crisis, to align with international standards and, more recently, to deal with cyclical pressures resulting in an acceleration of bank lending. In particular, regulatory reforms pertaining to loan classification and provisioning as well as liquidity requirements are reviewed and evaluated against best practices. The paper concludes that prudential regulation in Uruguay now generally conforms to high standards while also embracing innovative elements such as dynamic provisioning.
    Keywords: Bank reforms , Bank regulations , Bank supervision , Banking sector , Basel Core Principles , Business cycles , Credit expansion , Credit risk , Financial crisis , Financial soundness indicators , Liquidity management , Loans , Risk management , Uruguay ,
    Date: 2009–09–17
  10. By: Pierre-Richard Agénor; Koray Alper; Luiz Pereira da Silva
    Abstract: The business cycle effects of bank capital regulatory regimes are examined in a New Keynesian model with credit market imperfections and a cost channel of monetary policy. A key feature of the model is that bank capital increases incentives for banks to monitor borrowers, thereby reducing the probability of default. Basel I- and Basel II-type regulatory regimes are defined, and the model is calibrated for a middle-income country. Numerical simulations show that, depending on the elasticities that relate the repayment probability to its micro and macro determinants, and the elasticity of the risk weight (under Basel II) with respect to the repayment probability, Basel I may be more procyclical than Basel II in response to adverse supply and demand shocks.
    Date: 2009
  11. By: Onour, Ibrahim
    Abstract: This paper investigates estimation of extreme risk in a number of stock markets in the Gulf Cooperation Council (GCC) countries , Saudi, Kuwait, and United Arab Emirates, in addition to S& P 500 stock index, using the Generalized Pareto Distribution (GPD) model. The estimated tails parameter values for stock returns of Kuwait, Saudi, and Dubai, markets show the likelihood of significant extreme losses as well as significant extreme gains, compared to the case of more mature S&P 500 stock returns, which exhibit possibility of significant extreme losses with insignificant gain prospects.
    Keywords: VaR;Expected shortfall; risk;GCC stock markets
    JEL: C50 E00 E44
    Date: 2009–06–28
  12. By: William Francis (Financial Services Authority); Matthew Osborne (Financial Services Authority)
    Abstract: Using bank-level panel data from the United Kingdom, this paper investigates the factors that influence banking institutions' choice of risk-based capital ratios. Special focus is placed on evaluating whether and how institutions respond to changes in regulatory capital requirements and if these responses vary across the economic cycle. This issue is of particular interest to policymakers that rely on capital regulation in conjunction with other supervisory tools to affect bank behaviours and maintain market confidence and financial stability more broadly. The paper also explores the extent to which UK banks’ capital management practices were procyclical under Basel I. Understanding whether such practices existed under this less risk-sensitive (and potentially, less procyclical) regulatory capital regime is a useful first step towards determining if banks, in their capital management practices, consider swings in economic conditions on their capital positions and lending capacities, which may, in turn, impact on the severity and duration of such economic cycles. We find a statistically significant association between banks' risk-based capital ratios and individual capital requirements set by regulators in the UK. We also find that the rate at which banks respond to changing capital requirements depends significantly on certain characteristics of the bank (e.g., size, exposure to market discipline, nearness to regulatory threshold) as well as the direction of the economic cycle. We find a (marginally statistically significant) negative association between capital ratios and the economic cycle, but no association when we focus only on the largest banks in the UK, suggesting that systemically important banks tend to maintain risk-based capital ratios over the cycle (although we note that this finding is based on a sample period which does not contain a significant downturn). Further, we note a positive association between capital ratios and capital quality, suggesting that reliance on capital with relatively higher adjustment costs (e.g., tier 1 capital) may raise the profile of that consideration in capital management practices and lead cost-minimizing banks to maintain higher total risk-based capital ratios overall. Finally, we find a positive marginal effect of market discipline on total risk-based capital ratios held by UK banks. We interpret this result as suggesting that banks mitigate expected market reactions (e.g., on their funding costs or ability to access certain capital markets activities) to their business decisions by holding higher capital ratios.
    Keywords: bank, capital, financial regulation, prudential policy
    Date: 2009–03
  13. By: Gianni De Nicoló; John H. Boyd; Abu M. Jalal
    Abstract: We study a banking model in which banks invest in a riskless asset and compete in both deposit and risky loan markets. The model predicts that as competition increases, both loans and assets increase; however, the effect on the loans-to-assets ratio is ambiguous. Similarly, as competition increases, the probability of bank failure can either increase or decrease. We explore these predictions empirically using a cross-sectional sample of 2,500 U.S. banks in 2003, and a panel data set of about 2600 banks in 134 non-industrialized countries for the period 1993-2004. With both samples, we find that banks' probability of failure is negatively and significantly related to measures of competition, and that the loan-to-asset ratio is positively and significantly related to measures of competition. Furthermore, several loan loss measures commonly employed in the literature are negatively and significantly related to measures of bank competition. Thus, there is no evidence of a trade-off between bank competition and stability, and bank competition seems to foster banks' willingness to lend.
    Keywords: Asset management , Banking , Bankruptcy , Banks , Competition , Credit risk , Cross country analysis , Depositories , Economic models , Financial crisis , Time series , United States ,
    Date: 2009–07–10
  14. By: Adrian Pop (LEMNA - Laboratoire d'économie et de management de Nantes Atlantique - Université de Nantes : EA4272)
    Abstract: The logic behind the indirect channel of market discipline presumes that the pricing of bank debt in the secondary market, if accurate, conveys to supervisor and other market participants a reliable signal of bank's financial conditions and default risk. By collecting a unique dataset of spreads, ratings, and accounting measures of bank risk for a sample of large European banking organizations during the 1995—2002 period, we empirically test whether secondary market prices accurately reflect financial conditions of bank issuers. Our results complement the findings obtained by Sironi [Testing for market discipline in the European banking industry: Evidence from subordinated debt issues. Journal of Money, Credit, and Banking 35 (2003) 443-472] on the primary market of bank subordinated debt
    Date: 2009–09–23
  15. By: Gianni De Nicoló; Marcella Lucchetta
    Abstract: We study a simple general equilibrium model in which investment in a risky technology is subject to moral hazard and banks can extract market power rents. We show that more bank competition results in lower economy-wide risk, lower bank capital ratios, more efficient production plans and Pareto-ranked real allocations. Perfect competition supports a second best allocation and optimal levels of bank risk and capitalization. These results are at variance with those obtained by a large literature that has studied a similar environment in partial equilibrium. Importantly, they are empirically relevant, and demonstrate the need of general equilibrium modeling to design financial policies aimed at attaining socially optimal levels of systemic risk in the economy.
    Keywords: Banking sector , Banks , Borrowing , Capital , Competition , Corporate sector , Economic models , Financial intermediation , Financial risk , Investment , Risk management ,
    Date: 2009–05–21
  16. By: Romain Biard (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429); Stéphane Loisel (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429); Claudio Macci (Dipartimento di Matematica - Università di Roma "Tor Vergata"); Noel Veraverbeke (Center for Statistics - Hasselt University)
    Abstract: In the renewal risk model, we study the asymptotic behavior of the expected time-integrated negative part of the process. This risk measure has been introduced by Loisel (2005). Both heavy-tailed and light-tailed claim amount distributions are investigated. The time horizon may be finite or infinite. We apply the results to an optimal allocation problem with two lines of business of an insurance company. The asymptotic behavior of the two optimal initial reserves are computed.
    Keywords: Ruin theory; heavy-tailed and light-tailed claim size distribution; risk measure; optimal reserve allocation
    Date: 2009–09
  17. By: Dan Galai; Zvi Wiener
    Abstract: The paper shows how-in a Merton-type model with bankruptcy-the currency composition of debt changes the risk profile of a company raising a given amount of financing, and thus affects the cost of debt. Foreign currency borrowing is cheaper when the exchange rate is positively correlated with the return on the company's assets, even if the company is not an exporter. Prudential regulations should therefore differentiate among loans depending on the extent to which borrowers have "natural hedges" of their foreign currency exposures.
    Keywords: Asset prices , Bonds , Capital markets , Corporate sector , Credit risk , Currencies , Debt , Debt restructuring , Economic models , Exchange rates , Sovereign debt ,
    Date: 2009–05–27
  18. By: Ralph Chami; Sunil Sharma; Connel Fullenkamp
    Abstract: The paper proposes a framework for examining the process of financial market development. The framework, consistent with the functional view of financial system design, is anchored in studying the incentives facing the key players in financial markets-borrowers, lenders, liquidity providers, and regulators-whose actions determine whether and how markets develop. While different financial instruments embody different concessions by borrowers and lenders, the framework emphasizes the two main compromises: the tradeoffs between maturity and collateral, and between seniority and control. The framework is used to analyze the sequencing of financial market development.
    Keywords: Banking sector , Banks , Bond markets , Capital markets , Demand for money , Financial instruments , Financial risk , Financial sector , Financial systems , Loans , Risk management , Securities markets , Stock markets ,
    Date: 2009–07–28
  19. By: Olatundun Janet Adelegan
    Abstract: This paper examines the role of the derivatives market in South Africa and provides policy options for promoting the development of derivatives markets in sub-Saharan Africa. South Africa's derivatives market has grown rapidly in recent years, supporting capital inflows and helping market participants to price, unbundle and transfer risk. There are tight regulations on asset allocations by insurance and pension funds to prevent excessive risk taking. The development of derivatives markets in sub-Saharan African countries could enable market participants to self-insure against volatile capital flows. Theiroverdependence on bank credit as a source of funding could be reduced and their management of seasonal risk could be improved through the introduction of commodity futures. However, these markets must be appropriately regulated and supervised. Since such markets would likely be small, consideration should be given to the establishment of a regional derivatives market.
    Keywords: Bond markets , Capital flows , Capital markets , Financial instruments , Financial risk , Investment , Liquidity management , Risk management , Securities markets , Securities regulations , South Africa , Stock markets , Sub-Saharan Africa ,
    Date: 2009–09–15
  20. By: Gregorio Impavido; Ian Tower
    Abstract: This paper discusses the key sources of vulnerabilities for pension plans and insurance companies in light of the global financial crisis of 2008. It also discusses how these institutional investors transit shocks to the rest of the financial sector and economy. The crisis has re-ignited the policy debate on key issues such as: 1) the need for countercyclical funding and solvency rules; 2) the tradeoffs implied in marked based valuation rules; 3) the need to protect contributors towards retirement from excessive market volatility; 4) the need to strengthen group supervision for large complex financial institutions including insurance and pensions; and 5) the need to revisit the resolution and crisis management framework for insurance and pensions.
    Keywords: Asset management , Asset prices , Cross country analysis , External shocks , Financial crisis , Financial institutions , Financial risk , Insurance , Insurance regulations , Insurance supervision , Latin America , OECD , Pensions , Private investment ,
    Date: 2009–07–20
  21. By: Maria Delgado Coelho; Philippe Burger; Justin Tyson; I. Karpowicz
    Abstract: The paper investigates the impact of the global financial crisis on public-private partnerships (PPPs) and the circumstances under which providing support to new and existing projects is justified. Based on country evidence, cost of and access to finance are found to be the main channels of transmission of the financial crisis, affecting in particular pipeline PPP projects. Possible measures to help PPPs during the crisis include contract extensions, output-based subsidies, revenue enhancements and step-in rights. To limit government's exposure to risk, while preserving private partner's efficiency incentives, intervention measures should be consistent with the wider fiscal policy stance, be contingent on specific circumstances, and be adequately costed and budgeted. Governments should be compensated for taking on additional risk.
    Keywords: Credit risk , Cross country analysis , Financial crisis , Financial risk , Fiscal policy , Private sector , Public enterprises , Public investment , Public sector , Risk management ,
    Date: 2009–07–13
  22. By: Julien Chevallier (EconomiX - CNRS : UMR7166 - Université de Paris X - Nanterre); Yannick Le Pen (LEMNA - Laboratoire d'économie et de management de Nantes Atlantique - Université de Nantes : EA4272); Benoît Sévi (GRANEM - Department of Law, Economics, and Management - Université d'Angers)
    Abstract: To improve risk management in the European Union Emissions Trading Scheme (EU ETS), the European Climate Exchange (ECX) has introduced option instruments in October 2006 after regulatory authorization. The central question we address is: can we identify a potential destabilizing effect of the introduction of options on the underlying market (EU ETS futures)? Indeed, the literature on commodities futures suggest that the introduction of derivatives may either decrease (due to more market depth) or increase (due to more speculation) volatility. As the identification of these effects ultimately remains an empirical question, we use daily data from April 2005 to April 2008 to document volatility behavior in the EU ETS. By instrumenting various GARCH models, endogenous break tests, and rolling window estimations, our results overall suggest that the introduction of the option market had no effect on the volatility in the EU ETS. These finding are robust to other likely influences linked to energy and commodity markets.
    Date: 2009–09–23
  23. By: Barry J. Eichengreen
    Abstract: The Global Credit Crisis of 2008-09 has underscored the urgency of reforming the international financial architecture. While a number of short-term reforms are already in train, this paper contemplates more ambitious reforms of the international financial architecture that might be implemented over the next ten years. It proposes routinizing the expansion of IMF quotas and the conduct of exchange rate surveillance. It contemplates an expanded role for the SDR in international transactions, which would require someone-like the IMF-to act as market maker. It considers proposals for reimposing Glass-Steagall-like restrictions on commercial and investment banking, something that will have to be coordinated internationally to be feasible. Other proposals would require banks to purchase capital insurance; here the question is who would be on the other side of the market. Again there is likely to be a role for the IMF. Then there are arguments for a new agency or institution to deal with cross-border bank insolvencies. Any such entity will require staff support, which might plausibly come from the Fund. Finally, some insist that international colleges of regulators are not enough-that it is desirable to create a World Financial Organization (WFO) with the power to sanction members whose national regulatory policies are not up to international standards. A WFO will similarly need staff support, of which the IMF would be one possible source. All this of course presupposes meaningful IMF governance reform so that the institution has the legitimacy and efficiency to assume these additional responsibilities. The paper therefore concludes with some conventional and unconventional proposals for IMF governance reform.
    Keywords: Banking sector , Credit risk , Exchange rate policy surveillance , Financial crisis , Fund role , International cooperation , International financial system , Quota increases , Risk management , SDR role , SDR transactions , SDRs ,
    Date: 2009–05–29

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