New Economics Papers
on Risk Management
Issue of 2010‒02‒13
fourteen papers chosen by

  1. Macroprudential Regulation and Systemic Capital Requirements By Celine Gauthier; Alfred Lehar; Moez Souissi
  2. Too Interconnected To Fail: Financial Contagion and Systemic Risk in Network Model of CDS and Other Credit Enhancement Obligations of US Banks By Sheri Markose; Simone Giansante; Mateusz Gatkowski; Ali Rais Shaghaghi
  3. Containing systemic risk. By Whelan, Karl
  4. Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies By Andrew Ellul; Vijay Yerramilli
  5. An extension of Davis and Lo's contagion model By Didier Rullière; Diana Dorobantu; Areski Cousin
  6. Risk aggregation in Solvency II: How to converge the approaches of the internal models and those of the standard formula? By Laurent Devineau; Stéphane Loisel
  7. French savings communities exposed to Russian risks on assets in the 1900s-1920s. A few issues about the actual risks on financial pledges (In French) By Hubert BONIN (GREThA UMR CNRS 5113 - Institut de Sciences Politique de Bordeaux)
  8. Determinants of consumer financial risktaking:Evidence from deductible choice By Janko Gorter; Paul Schilp
  9. Asset returns and volatility clustering in financial time series By Jie-Jun Tseng; Sai-Ping Li
  10. Is this time different for Asia?: Evidence from stock Markets By Yushi Yoshida
  11. How to evaluate an Early Warning System ? By Elena-Ivona Dumitrescu; Christophe Hurlin; Bertrand Candelon
  12. Forecast horizon of 5th – 6th – 7th long wave and short-period of contraction in economic cycles By Coccia Mario
  13. Transfer Pricing as a Tax Compliance Risk By Jost, Sven P.; Pfaffermayr, Michael; Winner, Hannes
  14. New methods of estimating stochastic volatility and the stock return By Alghalith, Moawia

  1. By: Celine Gauthier; Alfred Lehar; Moez Souissi
    Abstract: In the aftermath of the financial crisis, there is interest in reforming bank regulation such that capital requirements are more closely linked to a bank's contribution to the overall risk of the financial system. In our paper we compare alternative mechanisms for allocating the overall risk of a banking system to its member banks. Overall risk is estimated using a model that explicitly incorporates contagion externalities present in the financial system. We have access to a unique data set of the Canadian banking system, which includes individual banks' risk exposures as well as detailed information on interbank linkages including OTC derivatives. We find that systemic capital allocations can differ by as much as 50% from 2008Q2 capital levels and are not related in a simple way to bank size or individual bank default probability. Systemic capital allocation mechanisms reduce default probabilities of individual banks as well as the probability of a systemic crisis by about 25%. Our results suggest that financial stability can be enhanced substantially by implementing a systemic perspective on bank regulation.
    Keywords: Financial stability
    JEL: G21 C15 C81 E44
    Date: 2010
  2. By: Sheri Markose; Simone Giansante; Mateusz Gatkowski; Ali Rais Shaghaghi
    Abstract: Credit default swaps (CDS) which constitute up to 98% of credit derivatives have had a unique, endemic and pernicious role to play in the current financial crisis. However, there are few in depth empirical studies of the financial network interconnections among banks and between banks and nonbanks involved as CDS protection buyers and protection sellers. The ongoing problems related to technical insolvency of US commercial banks is not just confined to the so called legacy/toxic RMBS assets on balance sheets but also because of their credit risk exposures from SPVs (Special Purpose Vehicles) and the CDS markets. The dominance of a few big players in the chains of insurance and reinsurance for CDS credit risk mitigation for banks’ assets has led to the idea of “too interconnected to fail” resulting, as in the case of AIG, of having to maintain the fiction of non-failure in order to avert a credit event that can bring down the CDS pyramid and the financial system. This paper also includes a brief discussion of the complex system Agent-based Computational Economics (ACE) approach to financial network modeling for systemic risk assessment. Quantitative analysis is confined to the empirical reconstruction of the US CDS network based on the FDIC Q4 2008 data in order to conduct a series of stress tests that investigate the consequences of the fact that top 5 US banks account for 92% of the US bank activity in the $34 tn global gross notional value of CDS for Q4 2008 (see, BIS and DTCC). The May-Wigner stability condition for networks is considered for the hub like dominance of a few financial entities in the US CDS structures to understand the lack of robustness. We provide a Systemic Risk Ratio and an implementation of concentration risk in CDS settlement for major US banks in terms of the loss of aggregate core capital. We also compare our stress test results with those provided by SCAP (Supervisory Capital Assessment Program). Finally, in the context of the Basel II credit risk transfer and synthetic securitization framework, there is little evidence that the CDS market predicated on a system of offsets to minimize final settlement can provide the credit risk mitigation sought by banks for reference assets in the case of a significant credit event. The large negative externalities that arise from a lack of robustness of the CDS financial network from the demise of a big CDS seller undermines the justification in Basel II that banks be permitted to reduce capital on assets that have CDS guarantees. We recommend that the Basel II provision for capital reduction on bank assets that have CDS cover should be discontinued.
    Date: 2010–02–02
  3. By: Whelan, Karl
    Abstract: Systemic risk refers to the risk of financial system breakdown due to linkages between institutions. This risk cannot be assessed by looking at how individual institutions manage risks but instead requires a full understanding of how the system as a whole operates. At present, the data available to central banks and financial regulators are not at all adequate for the task of assessing systemic risk and the new European Systemic Risk Board needs to address this issue. There is a lot of exciting ongoing research devoted to measuring systemic risk and providing signals to regulators as to when and where they should intervene. However, the tools being developed are still limited in their usefulness. Perhaps more pressing than the development of these tools is the implementation of policy measures to make the financial system more robust. These measures should include higher capital ratios, limits on non-core funding and redesigning financial systems to be less complex.
    Keywords: Financial institutions--Management; Risk--Europe; Financial institutions--Law and legislation--Europe; Financial crises--Prevention;
    Date: 2009–11
  4. By: Andrew Ellul; Vijay Yerramilli
    Abstract: In this paper, we investigate whether U.S. bank holding companies (BHCs) with strong and independent risk management functions had lower aggregate risk and downside risk. We hand-collect information on the organization structure of the 75 largest publicly-listed BHCs, and use this information to construct a Risk Management Index (RMI) that measures the strength of organizational risk controls at these institutions. We find that BHCs with a high RMI in the year 2006, i.e., before the onset of the financial crisis, had lower exposures to mortgage-backed securities and risky trading assets, were less active in trading off-balance sheet derivatives, and generally fared better in terms of operating performance and lower downside risk during the crisis years (2007 and 2008). In a panel spanning 8 years, we find that BHCs with higher RMIs had lower aggregate risk and downside risk, and higher stock returns, after controlling for size, profitability, a variety of risk characteristics, corporate governance, executive compensation, and BHC fixed effects. This result holds even after controlling for any simultaneity bias. Overall, these results suggest that strong internal risk controls are effective in lowering risk at banking institutions.
    Date: 2010–02
  5. By: Didier Rullière (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429); Diana Dorobantu (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429); Areski Cousin (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429)
    Abstract: The present paper provides a multi-period contagion model in the credit risk field. Our model is an extension of Davis and Lo's infectious default model. We consider an economy of n firms which may default directly or may be infected by other defaulting firms (a domino effect being also possible). The spontaneous default without external influence and the infections are described by not necessarily independent Bernoulli-type random variables. Moreover, several contaminations could be required to infect another firm. In this paper we compute the probability distribution function of the total number of defaults in a dependency context. We also give a simple recursive algorithm to compute this distribution in an exchangeability context. Numerical applications illustrate the impact of exchangeability among direct defaults and among contaminations, on different indicators calculated from the law of the total number of defaults. We then examine the calibration of the model on iTraxx data before and during the crisis. The dynamic feature together with the contagion effect seem to have a significant impact on the model performance, especially during the recent distressed period.
    Keywords: credit risk; contagion model; dependent defaults; default distribution; exchangeability; CDO tranches
    Date: 2009–04–08
  6. By: Laurent Devineau (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429, R&D, Milliman, Paris - Milliman); Stéphane Loisel (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429)
    Abstract: Two approaches may be considered in order to determine the Solvency II economic capital: the use of a standard formula or the use of an internal model (global or partial). However, the results produced by these two methods are rarely similar, since the underlying hypothesis of marginal capital aggregation is not verified by the projection models used by companies. We demonstrate that the standard formula can be considered as a first order approximation of the result of the internal model. We therefore propose an alternative method of aggregation that enables to satisfactorily capture the diversity among the various risks that are considered, and to converge the internal models and the standard formula.
    Date: 2009–12
  7. By: Hubert BONIN (GREThA UMR CNRS 5113 - Institut de Sciences Politique de Bordeaux)
    Abstract: Many pamphleteers in the 1900s-1920s and of short-sighted histories criticised French investments in Russia. They accused on the moment or retrospectively bankers and financiers of having involved savers’ cash (that of “France des petits” and middle classes) in the “adventure” of “emprunts russes”. Our paper intends to argue about the reality of the portfolio of risk analysis of which banks equipped themselves in order to set up a capital of skills and to draw a “curb of experience”, to apply them to risks management fostered by assets committed to eastern Europe.
    Keywords: Bank; Risk analysis; Risk management; Investments in Russia; Emprunts russes; Market confidence; Risk saving
    JEL: N2 N24 F36
    Date: 2010
  8. By: Janko Gorter; Paul Schilp
    Abstract: We analyze a clear-cut example of choice under uncertainty, namely deductible choice in the Dutch health insurance market. The unique institutional features of this market enable us to examine demand-side choices that only vary in their financial parameters. Using a rich dataset, we investigate the theoretical determinants of deductible choice. In line with expected-utility theory, we find that healthier, wealthier and more risk-tolerant consumers choose higher levels of deductibility. Consumer choice for financial risk is thus driven by various considerations, not only by risk type. Heterogeneity in risk preferences seems at least as important in explaining financial risk-taking. These results are not only relevant to insurance markets but to all markets where consumers decide on financial risk.
    Keywords: Financial Risk; Risk Tolerance; Adverse Selection; Deductible; Insurance
    JEL: D12 D81 G22
    Date: 2010–01
  9. By: Jie-Jun Tseng; Sai-Ping Li
    Abstract: An analysis of the stylized facts in financial time series is carried out. We find that, instead of the heavy tails in asset return distributions, the slow decay behaviour in autocorrelation functions of absolute returns is actually directly related to the degree of clustering of large fluctuations within the financial time series. We also introduce an index to quantitatively measure the clustering behaviour of fluctuations in these time series and show that big losses in financial markets usually lump more severely than big gains. We further give examples to demonstrate that comparing to conventional methods, our index enables one to extract more information from the financial time series.
    Date: 2010–02
  10. By: Yushi Yoshida (Faculty of Economics, Kyushu Sangyo University)
    Abstract: The recent sub-prime financial crisis initially affected the Asian economy to a degree comparable to that of the downturn in the Asian financial crisis; however, the recovery in Asia took place at a much faster pace than during the Asian financial crisis. We investigate whether the effects of sub-prime financial crisis on 13 Asian economies are similar to those of the previous crisis, by examining stock markets for volatility spillovers and causality directions between the US and Asia as well as for the degree of regional integration. The empirical evidence indicates stark differences between these two crises. First, the decline in volatility spillovers during the period of financial turmoil was more pervasive for the Asian financial crisis. Second, the estimated point of transition in correlation is indicative of market participants’ awareness of the upcoming stock market crash in September 2008. Third, the causality from the epicenter of crises is intensified during crisis. Fourth, regional integration was strengthened after the financial turmoil of the recent sub-prime financial crisis but not after the Asian financial crisis.
    Keywords: Asia, Contagion, Financial crisis, Spillover, Stock market integration.
    JEL: F31 F36 G15
    Date: 2010–02
  11. By: Elena-Ivona Dumitrescu (LEO - Laboratoire d'économie d'Orleans - CNRS : UMR6221 - Université d'Orléans); Christophe Hurlin (LEO - Laboratoire d'économie d'Orleans - CNRS : UMR6221 - Université d'Orléans); Bertrand Candelon (Laboratoire d'Economie d'Orléans - Université d'Orléans - CNRS : FRE2783)
    Abstract: This paper proposes a new statistical framework originating from the traditional credit- scoring literature, to evaluate currency crises Early Warning Systems (EWS). Based on an assessment of the predictive power of panel logit and Markov frameworks, the panel logit model is outperforming the Markov switching specifications. Furthermore, the introduction of forward-looking variables clearly improves the forecasting properties of the EWS. This improvement confirms the adequacy of the second generation crisis models in explaining the occurrence of crises.
    Keywords: currency crisis; Early Warning System; credit-scoring
    Date: 2010–01–01
  12. By: Coccia Mario (Ceris - Institute for Economic Research on Firms and Growth, Moncalieri (Turin), Italy)
    Abstract: The purpose of this essay is to determine the forecast horizon of the fifth, sixth and seventh long wave. As the period of each long wave can change according to the data, it has been used a deterministic approach, based on historical chronologies of USA and UK economies worked out by several scholars, to determine average timing, period and forecast error of future long waves. In addition, the analysis shows that long waves have average upwave period longer than average downwave one. This result is also confirmed by US Business Cycles that have average contractions shorter than expansions phase over time.
    Keywords: Forecast Horizon, Long Waves, Kondratieff Waves, Business Cycles, Asymmetric Path
    JEL: E30 E37
    Date: 2009–12
  13. By: Jost, Sven P. (Department of Economics and Statistics, University of Innsbruck); Pfaffermayr, Michael (Department of Economics and Statistics, University of Innsbruck); Winner, Hannes (University of Salzburg)
    Abstract: This paper contributes to the empirical literature on the transfer pricing behavior of multinational firms. Previous research mainly focuses on transfer pricing as a means of tax optimization. Our approach concentrates on transfer pricing as a critical compliance issue. Specifically, we investigate whether and to what extent the awareness of transfer pricing as a tax compliance issue responds to country and industry characteristics as well as firm-specifics. Empirically, the transfer pricing risk awareness is measured as a professional assessment reported by the person with ultimate responsibility for transfer pricing in their company. Based on a unique global survey conducted by a Big 4 accounting firm in 2007 and 2008, we estimate the number of firms reporting transfer pricing being the largest risk issue with regard to subsequent tax payments. We find that transfer pricing risk awareness depends on variables accounting for general tax and transfer pricing specific strategies, the types and characteristics of intercompany transactions the multinational firms are involved in, their individual transfer pricing compliance efforts and resources dedicated to transfer pricing matters.
    Keywords: Transfer pricing; international taxation; multinational firms; tax risk management
    JEL: F23 H25
    Date: 2010–02–03
  14. By: Alghalith, Moawia
    Abstract: We present a new method of estimating the asset stochastic volatility and return. In doing so, we overcome some of the limitations of the existing random walk models, such as the GARCH/ARCH models.
    Keywords: portfolio; investment; stock; stochastic volatility
    JEL: C13 G12 G0
    Date: 2010–01–28

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