New Economics Papers
on Risk Management
Issue of 2009‒11‒27
fifteen papers chosen by

  1. Mitigating the Procyclicality of Basel II By Repullo, Rafael; Saurina, Jesús; Trucharte, Carlos
  2. Commercial Bank Loan Loss Recoveries By Kurt Hess; Arthur Grimes
  3. Regulatory Competition and Bank Risk Taking By Agur, Itai
  4. The StressVaR: A New Risk Concept for Superior Fund Allocation By Cyril Coste; Raphael Douady; Ilija I. Zovko
  5. Global Market Conditions and Systemic Risk By Heiko Hesse; Brenda González-Hermosillo
  6. "It Pays to Violate: How Effective are the Basel Accord Penalties?" By Bernardo da Veiga; Felix Chan; Michael McAleer
  7. When Everyone Runs for the Exit By Pedersen, Lasse Heje
  8. Symmetric vs. Downside Risk: Does It Matter for Portfolio Choice? By Olga Bourachnikova; Nurmukhammad Yusupov
  9. Basel core principles and bank soundness : does compliance matter ? By Demirguc-Kunt, Asli; Detragiache, Enrica
  10. Credit Derivatives: Systemic Risks and Policy Options? By Jennifer A. Elliott; John Kiff; Elias G. Kazarian; Jodi G. Scarlata; Carolyne Spackman
  11. Accounting discretion of banks during a financial crisis By Huizinga, Harry; Laeven, Luc
  12. Excessive Lending, Leverage, and Risk-Taking in the Presence of Bailout Expectations By Andréas Georgiou
  13. Generalized Extreme Value Distribution with Time-Dependence Using the AR and MA Models in State Space Form By Jouchi Nakajima; Tsuyoshi Kunihama; Yasuhiro Omori; Sylvia Fruwirth-Scnatter
  14. The Superiority of Time-Varying Hedge Ratios in Turkish Futures By Onur Olgun; Ý. Hakan Yetkiner
  15. Macro-Hedging for Commodity Exporters By Damiano Sandri; Eduardo Borensztein; Olivier Jeanne

  1. By: Repullo, Rafael; Saurina, Jesús; Trucharte, Carlos
    Abstract: This paper compares alternative procedures to mitigate the procyclicality of the new risk-sensitive bank capital regulation (Basel II). We estimate a model of the probabilities of default (PDs) of Spanish firms during the period 1987-2008, and use the estimated PDs to compute the corresponding series of Basel II capital requirements per unit of loans. These requirements move significantly along the business cycle, ranging from 7.6% (in 2006) to 11.9% (in 1993). The comparison of the different procedures is based on the criterion of minimizing the root mean square deviations of each smoothed series with respect to the Hodrick-Prescott trend of the original series. The results show that the best procedures are either to smooth the inputs of the Basel II formula by using through-the-cycle PDs or to smooth the output with a multiplier based on GDP growth. Our discussion concludes that the latter is better in terms of simplicity, transparency, and consistency with banks’ risk pricing and risk management systems. For the portfolio of Spanish commercial and industrial loans and a 45% loss given default (LGD), the multiplier would amount to a 6.5% surcharge for each standard deviation in GDP growth. The surcharge would be significantly higher with cyclically-varying LGDs.
    Keywords: Bank capital regulation; Basel II; Business cycles; Credit crunch; Procyclicality
    JEL: E32 G28
    Date: 2009–07
  2. By: Kurt Hess (University of Waikato); Arthur Grimes (Motu Economic and Public Policy Research and University of Waikato)
    Abstract: We present a new approach to analyse historical recovery rates on distressed bank assets. Our approach uses banks’ reported impaired assets and the corresponding specific provisions. The dynamics and drivers of this credit loss recovery proxy are studied for a comprehensive sample of Australian banks from 1989 to 2005. We find that macroeconomic and bank-specific factors influence banks’ estimates of loan loss recoveries, consistent with banks smoothing their earnings. In contrast with findings based on prices of distressed corporate bonds, banks record lower recoveries in years of strong economic growth.
    Keywords: banking; credit risk; loan loss recoveries; loss given default; Australia
    JEL: G20 G21
    Date: 2009–11–01
  3. By: Agur, Itai
    Abstract: How damaging is competition between bank regulators? This paper models regulators that compete because they want to supervise more banks. Both banks' risk profiles and their access to wholesale funding are endogenous, leading to rich interactions. The sensitivity of regulatory standards to bank moral hazard, adverse selection, liquidity risk and the degree of regulatory bias is investigated. A calibration suggests that regulatory reform can halve bank default rates. The paper also shows how a decline in regulators' monitoring capacity gives rise to a gradual rise in bank risk, followed by a sudden interbank crisis.
    Keywords: Arbitrage; Bank default; Interbank market; Moral hazard; Supervision
    JEL: G21 G28
    Date: 2009–10
  4. By: Cyril Coste; Raphael Douady; Ilija I. Zovko
    Abstract: In this paper we introduce a novel approach to risk estimation based on nonlinear factor models - the "StressVaR" (SVaR). Developed to evaluate the risk of hedge funds, the SVaR appears to be applicable to a wide range of investments. Its principle is to use the fairly short and sparse history of the hedge fund returns to identify relevant risk factors among a very broad set of possible risk sources. This risk profile is obtained by calibrating a collection of nonlinear single-factor models as opposed to a single multi-factor model. We then use the risk profile and the very long and rich history of the factors to asses the possible impact of known past crises on the funds, unveiling their hidden risks and so called "black swans". In backtests using data of 1060 hedge funds we demonstrate that the SVaR has better or comparable properties than several common VaR measures - shows less VaR exceptions and, perhaps even more importantly, in case of an exception, by smaller amounts. The ultimate test of the StressVaR however, is in its usage as a fund allocating tool. By simulating a realistic investment in a portfolio of hedge funds, we show that the portfolio constructed using the StressVaR on average outperforms both the market and the portfolios constructed using common VaR measures. For the period from Feb. 2003 to June 2009, the StressVaR constructed portfolio outperforms the market by about 6% annually, and on average the competing VaR measures by around 3%. The performance numbers from Aug. 2007 to June 2009 are even more impressive. The SVaR portfolio outperforms the market by 20%, and the best competing measure by 4%.
    Date: 2009–11
  5. By: Heiko Hesse; Brenda González-Hermosillo
    Abstract: This paper examines several key global market conditions, such as a proxy for market uncertainty and measures of interbank funding stress, to assess financial volatility and the likelihood of crisis. Using Markov regime-switching techniques, it shows that the Lehman Brothers failure was a watershed event in the crisis, although signs of heightened systemic risk could be detected as early as February 2007. In addition, we analyze the role of global market conditions to help determine when governments should begin to exit their extraordinary public support measures.
    Keywords: Banking sector , Central bank policy , Currency swaps , Developing countries , Economic models , Financial crisis , Financial risk , Financial systems , Fiscal policy , International capital markets , Nonbank financial sector , Risk management ,
    Date: 2009–10–22
  6. By: Bernardo da Veiga (School of Economics and Finance, Curtin University of Technology); Felix Chan (School of Economics and Finance, Curtin University of Technology); Michael McAleer (Econometric Institute, Erasmus School of Economics, Erasmus University Rotterdam and Tinbergen Institute and Center for International Research on the Japanese Economy (CIRJE), Faculty of Economics, University of Tokyo)
    Abstract: The internal models amendment to the Basel Accord allows banks to use internal models to forecast Value-at-Risk (VaR) thresholds, which are used to calculate the required capital that banks must hold in reserve as a protection against negative changes in the value of their trading portfolios. As capital reserves lead to an opportunity cost to banks, it is likely that banks could be tempted to use models that underpredict risk, and hence lead to low capital charges. In order to avoid this problem the Basel Accord introduced a backtesting procedure, whereby banks using models that led to excessive violations are penalised through higher capital charges. This paper investigates the performance of five popular volatility models that can be used to forecast VaR thresholds under a variety of distributional assumptions. The results suggest that, within the current constraints and the penalty structure of the Basel Accord, the lowest capital charges arise when using models that lead to excessive violations, thereby suggesting the current penalty structure is not severe enough to control risk management. In addition, an alternative penalty structure is suggested to be more effective in aligning the interests of banks and regulators.
    Date: 2009–10
  7. By: Pedersen, Lasse Heje
    Abstract: The dangers of shouting ``fire'' in a crowded theater are well understood, but the dangers of rushing to the exit in the financial markets are more complex. Yet, the two events share several features, and I analyze why people crowd into theaters and trades, why they run, what determines the risk, whether to return to the theater or trade when the dust settles, and how much to pay for assets (or tickets) in light of this risk. These theoretical considerations shed light on the recent global liquidity crisis and, in particular, the quant event of 2007.
    Keywords: asset pricing; crisis; liquidity risk; quant; risk management; run; unconventional monetary policy
    JEL: E2 E44 E52 G1 G11 G12 G2
    Date: 2009–08
  8. By: Olga Bourachnikova (Laboratoire de Recherche en Gestion et Economie, EM Strasbourg, Université de Strasbourg); Nurmukhammad Yusupov (Audencia Nantes School of Management)
    Abstract: While symmetric measures of risk, such as variance, have been conven- tionally used in ?nance, downside risk measures are arguably more intuitive although computationally more complex to use. Opponents of symmetric risk measures suggest that investors use downside risk approach to invest- ment decisions. In this paper, using French stock market data, we empir- ically test whether the two approaches to portfolio optimization produce signi?cantly di¤erent outcomes. Our results suggest portfolio choice under downside risk and symmetric risk frameworks yield similar results. Our paper contributes to the ongoing debate on the relevance of symmetric vs. downside risk measures.
    JEL: G11
    Date: 2009
  9. By: Demirguc-Kunt, Asli; Detragiache, Enrica
    Abstract: This paper studies whether compliance with the Basel Core Principles for effective banking supervision is associated with bank soundness. Using data for more than 3,000 banks in 86 countries, the authors find that neither the overall index of compliance with the Basel Core Principles nor the individual components of the index are robustly associated with bank risk measured by Z-scores. The results of the analysis cast doubt on the usefulness of the Basel Core Principles in ensuring bank soundness.
    Keywords: Banks&Banking Reform,Public Sector Corruption&Anticorruption Measures,Financial Intermediation,Debt Markets,Hazard Risk Management
    Date: 2009–11–01
  10. By: Jennifer A. Elliott; John Kiff; Elias G. Kazarian; Jodi G. Scarlata; Carolyne Spackman
    Abstract: Credit derivative markets are largely unregulated, but calls are increasingly being made for changes to this "hands off" stance, amidst concerns that they helped to fuel the current financial crisis, or that they could be a cause of the next one. The purpose of this paper is to address two basic questions: (i) do credit derivative markets increase systemic risk; and (ii) should they be regulated more closely, and if so, how and to what extent? The paper begins with a basic description of credit derivative markets and recent events, followed by an assessment of their recent association with systemic risk. It then reviews and evaluates some of the authorities' proposed initiatives, and discusses some alternative directions that could be taken.
    Date: 2009–11–16
  11. By: Huizinga, Harry; Laeven, Luc
    Abstract: This paper presents evidence of banks using accounting discretion to overstate the value of distressed assets. In particular, we show that the stock market applies far greater discounts to a bank’s real estate loans and mortgage-backed securities than are implicit in the book values of these assets, especially following the onset of the U.S. mortgage crisis. This suggests that bank balance sheets overvalue real estate related assets during economic slowdowns. Estimated discounts are smaller for distressed banks, as these banks derive relatively large benefits from the financial safety net to offset asset impairment. We also find that bank share prices, especially for banks with large exposures to mortgage-backed securities, react favorably to recent changes in accounting rules that relax fair value accounting. Banks with large exposures to mortgage-backed securities are also found to provision less for bad loans. Finally, we find that banks, and especially distressed banks, use discretion in the classification of mortgage-backed securities so as to inflate the book value of these securities. Our results provide several pieces of compelling evidence that banks’ balance sheets offer a distorted view of the financial health of the banks, especially for banks with large exposures to real estate loans and mortgage-backed securities, and suggest that recent changes that relax fair value accounting may further distort this picture.
    Keywords: accounting standards; bank regulation; fair value accounting; financial crisis; mortgage-backed securities; real estate loans
    JEL: G14 G21
    Date: 2009–07
  12. By: Andréas Georgiou
    Abstract: The financial crisis that began in 2007 has brought to the fore the issues of excesses in lending, leverage, and risk-taking as some of the fundamental causes of this crisis. At the same time, in dealing with the financial crisis there have been large scale interventions by governments, often referred to as bailouts of the lenders. This paper presents a framework where rational economic agents engage in ex ante excessive lending, borrowing, and risk-taking if creditors assign a positive probability to being bailed out. The paper also offers some thoughts on policy implications. It argues that it would be most productive for the long run if lending institutions were not bailed out. If the continuing existence of an institution was deemed essential, assistance should take the form of capital injections that dilute the equity of existing owners.
    Keywords: Banking sector , Borrowing , Economic models , Financial crisis , Financial risk , Fiscal policy , Intervention , Investment , Loans , Nonbank financial sector ,
    Date: 2009–10–26
  13. By: Jouchi Nakajima (Institute for Monetary and Economic Studies, Bank of Japan. Currently in the Personnel and Corporate Affairs Department ( studying at Duke University, E-mail:; Tsuyoshi Kunihama (Graduate student, Graduate School of Economics, University of Tokyo. (E-mail:; Yasuhiro Omori (Professor, Faculty of Economics, University of Tokyo. (E-mail:; Sylvia Fruwirth-Scnatter (Professor, Department of Applied Statistics, Johannes Kepler University in Lintz. (E-mail:
    Abstract: A new state space approach is proposed to model the time- dependence in an extreme value process. The generalized extreme value distribution is extended to incorporate the time-dependence using a state space representation where the state variables either follow an autoregressive (AR) process or a moving average (MA) process with innovations arising from a Gumbel distribution. Using a Bayesian approach, an efficient algorithm is proposed to implement Markov chain Monte Carlo method where we exploit a very accurate approximation of the Gumbel distribution by a ten-component mixture of normal distributions. The methodology is illustrated using extreme returns of daily stock data. The model is fitted to a monthly series of minimum returns and the empirical results support strong evidence for time-dependence among the observed minimum returns.
    Keywords: Extreme values, Generalized extreme value distribution, Markov chain Monte Carlo, Mixture sampler, State space model, Stock returns
    JEL: C11 C51
    Date: 2009–11
  14. By: Onur Olgun (Department of International Trade and Finance, Izmir University of Economics); Ý. Hakan Yetkiner (Department of Economics, Izmir University of Economics)
    Abstract: This paper aims to compare the effectiveness of constant hedge ratio estimates (obtained through OLS and VECM methods) and time-varying hedge ratio estimates (obtained via M-GARCH method) for future contracts of ISE-30 index of TurkDEX. We use portfolio variance reduction as the measure of hedging effectiveness. We find that time-varying hedge ratios outperform the constant ratios for both in-sample and out-of-sample datasets and provide the minimum variance values.
    Keywords: Futures Pricing, Hedging, MGARCH, Hedging Effectiveness
    JEL: G13
    Date: 2009–11
  15. By: Damiano Sandri; Eduardo Borensztein; Olivier Jeanne
    Abstract: This paper uses a dynamic optimization model to estimate the welfare gains of hedging against commodity price risk for commodity-exporting countries. The introduction of hedging instruments such as futures and options enhances domestic welfare through two channels. First, by reducing export income volatility and allowing for a smoother consumption path. Second, by reducing the country's need to hold foreign assets as precautionary savings (or by improving the country's ability to borrow against future export income). Under plausibly calibrated parameters, the second channel may lead to much larger welfare gains, amounting to several percentage points of annual consumption.
    Keywords: Commodities , Commodity price fluctuations , Cross country analysis , Developing countries , Economic models , Export earnings , Export markets , Financial instruments , Financial risk , Hedge funds , International trade , Risk management ,
    Date: 2009–10–21

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