nep-rmg New Economics Papers
on Risk Management
Issue of 2010‒09‒25
twelve papers chosen by
Stan Miles
Thompson Rivers University

  1. Risk-return Efficiency, Financial Distress Risk, and Bank Financial Strength Ratings By Changchun Hua; Li-Gang Liu
  2. Fast remote but not extreme quantiles with multiple factors. Applications to Solvency II and Enterprise Risk Management By Matthieu Chauvigny; Laurent Devineau; Stéphane Loisel; Véronique Maume-Deschamps
  3. Four Futures for Finance: a scenario study By Michiel Bijlsma; Wouter Elsenburg; Michiel van Leuvensteijn
  4. Model Selection and Testing of Conditional and Stochastic Volatility Models By Massimiliano Caporin; Michael McAleer
  5. The effects of national discretions on banks By Isabel Argimón; Jenifer Ruiz
  6. The information content of high-frequency data for estimating equity return models and forecasting risk By Dobrislav P. Dobrev; Pawel J. Szerszen
  7. A yield spread perspective on the great financial crisis: break-point test evidence By Massimo Guidolin; Yu Man Tam
  8. A contribution to the systematics of stochastic volatility models By Frantisek Slanina
  9. Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting By Viral V. Acharya; Hamid Mehran; Anjan Thakor
  10. Do firms sell forward for strategic reasons? An application to the wholesale market for natural gas By van Eijkel, Remco; Moraga-González, Jose L.
  11. Safe and Sound Banking: A Role for Countercyclical Regulatory Requirements? By Gerard Caprio
  12. Gathering insights on the forest from the trees: a new metric for financial conditions By Scott Brave; R. Andrew Butters

  1. By: Changchun Hua; Li-Gang Liu (Asian Development Bank Institute)
    Abstract: This paper investigates whether there is any consistency between banks’ financial strength ratings (bank rating) and their risk-return profiles. It is expected that banks with high ratings tend to earn high expected returns for the risks they assume and thereby have a low probability of experiencing financial distress. Bank ratings, a measure of a bank’s intrinsic safety and soundness, should therefore be able to capture the bank’s ability to manage financial distress while achieving risk-return efficiency. We first estimate the expected returns, risks, and financial distress risk proxy (the inverse z-score), then apply the stochastic frontier analysis (SFA) to obtain the risk-return efficiency score for each bank, and finally conduct ordered logit regressions of bank ratings on estimated risks, risk-return efficiency, and the inverse z-score by controlling for other variables related to each bank’s operating environment. We find that banks with a higher efficiency score on average tend to obtain favorable ratings. It appears that rating agencies generally encourage banks to trade expected returns for reduced risks, suggesting that these ratings are generally consistent with banks’ risk-return profiles.
    Keywords: banking, financial strength ratings, risk-return profiles, stochastic frontier analysis
    JEL: D21 D24 G21 G24 G28 G32
    Date: 2010
  2. By: Matthieu Chauvigny (R&D Milliman - Milliman); Laurent Devineau (R&D Milliman - Milliman, 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); Véronique Maume-Deschamps (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429)
    Abstract: For operational purposes, in Enterprise Risk Management or in insurance for example, it may be important to estimate remote (but not extreme) quantiles of some function ƒ of some random vector. The call to ƒ may be time- and resource-consuming so that one aims at reducing as much as possible the number of calls to ƒ. In this paper, we propose some ways to address this problem of general interest. We then numerically analyze the performance of the method on insurance and Enterprise Risk Management real-world case studies.
    Date: 2010–09
  3. By: Michiel Bijlsma; Wouter Elsenburg; Michiel van Leuvensteijn
    Abstract: We develop four scenarios for the future of finance. Our scenarios differ in two dimensions. First, to what extent soft information lies at the core of banks' business. Second, to what extent scope economies exist between different banking activities. By combining these two dimensions, we obtain four scenarios: Isolated Islands, Big Banks, Competing Conglomerates, and Flat Finance. Market structure, market failures, and government failures vary between scenarios. These differences then translate into differences in the complexity of balance sheets, the ability to coordinate policy internationally, the information gap faced by regulators, the size of banks' balance sheets, the tradability of banks' assets, the level of interconnectedness, the potential for market discipline, and the threat of regulatory capture. As a result, each scenario calls for a different set of policies to combat systemic risk.
    Keywords: Financial sector
    JEL: G28
    Date: 2010–09
  4. By: Massimiliano Caporin; Michael McAleer (University of Canterbury)
    Abstract: This paper focuses on the selection and comparison of alternative non-nested volatility models. We review the traditional in-sample methods commonly applied in the volatility framework, namely diagnostic checking procedures, information criteria, and conditions for the existence of moments and asymptotic theory, as well as the out-of-sample model selection approaches, such as mean squared error and Model Confidence Set approaches. The paper develops some innovative loss functions which are based on Value-at-Risk forecasts. Finally, we present an empirical application based on simple univariate volatility models, namely GARCH, GJR, EGARCH, and Stochastic Volatility that are widely used to capture asymmetry and leverage.
    Keywords: Volatility model selection; volatility model comparison; non-nested models; model confidence set; Value-at-Risk forecasts; asymmetry, leverage
    JEL: C11 C22 C52
    Date: 2010–09–01
  5. By: Isabel Argimón (Banco de España); Jenifer Ruiz (European University Institute, Florence)
    Abstract: The EU's transposition of Basel II into European law has been done through the Capital Requirements Directive (CRD). Although the Directive establishes, in general, uniform rules to set capital requirements across European countries, there are some areas where the Directive allows some heterogeneity. In particular, countries are asked to choose among different possibilities when transposing the Directive, which are called national discretions (ND). The main objective of our research is to use such observed heterogeneity to gather empirical evidence on the effects on European banks of more or less stringency and more or less risk sensitivity in capital requirements. Following the approach in Barth et al. (2004, 2006, 2008) we build index numbers for groups of national discretions and applying Altunbas et al. (2007) approach, we provide evidence on their effect on banks' risk, capital, efficiency and cost. We show that more stringency and more risk sensitivity in regulation not always result in a trade off between efficiency and solvency: the impact depends on the area of national discretion on which such characteristics apply.
    Keywords: Prudential regulation, capital requirements, bank capital, risk, efficiency
    JEL: E61 G21 G28
    Date: 2010–09
  6. By: Dobrislav P. Dobrev; Pawel J. Szerszen
    Abstract: We demonstrate that the parameters controlling skewness and kurtosis in popular equity return models estimated at daily frequency can be obtained almost as precisely as if volatility is observable by simply incorporating the strong information content of realized volatility measures extracted from high-frequency data. For this purpose, we introduce asymptotically exact volatility measurement equations in state space form and propose a Bayesian estimation approach. Our highly efficient estimates lead in turn to substantial gains for forecasting various risk measures at horizons ranging from a few days to a few months ahead when taking also into account parameter uncertainty. As a practical rule of thumb, we find that two years of high frequency data often suffice to obtain the same level of precision as twenty years of daily data, thereby making our approach particularly useful in finance applications where only short data samples are available or economically meaningful to use. Moreover, we find that compared to model inference without high-frequency data, our approach largely eliminates underestimation of risk during bad times or overestimation of risk during good times. We assess the attainable improvements in VaR forecast accuracy on simulated data and provide an empirical illustration on stock returns during the financial crisis of 2007-2008.
    Date: 2010
  7. By: Massimo Guidolin; Yu Man Tam
    Abstract: We use a simple partial adjustment econometric framework to investigate the effects of the crisis on the dynamic properties of a number of yield spreads. We find that the crisis has caused substantial disruptions revealed by changes in the persistence of the shocks to spreads as much as by in their unconditional mean levels. Formal breakpoint tests confirm that the financial crisis has been over approximately since the Spring of 2009. The financial crisis can be conservatively dated as a August 2007 – June 2009 phenomenon, although some yield spread series seem to point out to an end of the most serious disruptions as early as in December 2008. We uncover evidence that the LSAP program implemented by the Fed in the US residential mortgage market has been effective, in the sense that the risk premia in this market have been uniquely shielded from the disruptive effects of the crisis.
    Keywords: Financial crises ; Risk
    Date: 2010
  8. By: Frantisek Slanina
    Abstract: We compare systematically several classes of stochastic volatility models of stock market fluctuations. We show that the long-time return distribution is either Gaussian or develops a power-law tail, while the short-time return distribution has generically a stretched-exponential form, but can assume also an algebraic decay, in the family of models which we call ``GARCH''-type. The intermediate regime is found in the exponential Ornstein-Uhlenbeck process. We calculate also the decay of the autocorrelation function of volatility.
    Date: 2010–09
  9. By: Viral V. Acharya; Hamid Mehran; Anjan Thakor
    Abstract: This paper examines how much capital banks should optimally hold. Our model encompasses different kinds of moral hazard studied in banking: asset substitution (or risk shifting, e.g., making risky, negative net present value loans), managerial rent seeking (e.g., shirking or investing in inefficient “pet” projects that yield private benefits), and the free cash flow problem (manifesting as inefficient consumption of cash for perquisites by the manager). The privately optimal capital structure of the bank balances the benefit of leverage as reflected in the market discipline imposed by uninsured creditors on rent seeking on the one hand and the cost of leverage as reflected in the asset substitution induced at high levels of leverage on the other hand. Under some conditions, the capital structure resolves all the moral hazard problems we study, but under other conditions, the goal of having the market discipline of leverage clashes with the goal of having the benefit of equity capital in attenuating asset substitution moral hazard. In this case, private contracting must tolerate some form of inefficiency and bank value is not maximized as it is in the first best. Despite this, there is no economic rationale for regulation. However, when bank failures are correlated and en masse failures can impose significant social costs, regulators may intervene ex post via bank bailouts. Anticipation of this generates multiple Nash equilibria, one of which features systemic risk in that all banks choose inefficiently high leverage, take excessively correlated asset risk, and, because debt is paid off by regulators when banks fail en masse, market discipline is compromised. While a simple minimum (tier-1) capital requirement suffices to restore efficiency under some conditions, there are also conditions under which an optimal arrangement to contain the build-up of systemic risk takes the form of the regular (tier-1) capital requirement plus a “special capital account” that involves 1) building up capital via dividend payout restrictions, 2) investment of the retained earnings in designated assets, and 3) contingent distribution provisions.
    Keywords: Bank capital ; Bank reserves ; Financial leverage ; Systemic risk ; Bank failures
    Date: 2010
  10. By: van Eijkel, Remco (University of Groningen); Moraga-González, Jose L. (IESE Business School)
    Abstract: Building on a model of the interaction of risk-averse firms that compete in forward and spot markets, we develop an empirical strategy to test whether oligopolistic firms use forward contracts for strategic motives, for risk-hedging, or for both. An increase in the number of players weakens the incentives to sell forward for risk-hedging reasons. However, if strategic motives are also relevant, then an increase in the number of players strengthens the incentives to sell forward. This difference provides the analyst with a way to identify whether strategic considerations are important at motivating firms to sell forward. Using data from the Dutch wholesale market for natural gas, where we observe the number of players, spot and forward sales, and churn rates, we find evidence that strategic reasons play an important role in explaining the observed firms' (inverse) hedge ratios. The data also lend support to the existence of a learning effect by wholesalers.
    Keywords: market power; risk-hedging; forward contracts; spot market; over-thecounter trade; market transparency; churn rates;
    JEL: D43 G13 L13 L95
    Date: 2010–06–05
  11. By: Gerard Caprio (Williams College)
    Abstract: Most explanations of the crisis of 2007-2009 emphasize the role of the preceding boom in real estate and asset markets in a variety of advanced countries. As a result, an idea that is gaining support among various groups is how to make Basel II or any regulatory regime less procyclical. This paper addresses the rationale for and likely contribution of such policies. Making provisioning (or capital) requirements countercyclical is one way potentially to address procyclicality, and accordingly it looks at the efforts of the authorities in Spain and Colombia, two countries in which countercyclical provisioning has been tried, to see what the track record has been. As explained there, these experiments have been at best too recent and limited to put much weight on them, but they are much less favorable for supporting this practice than is commonly admitted. The paper then addresses concerns and implementation issues with countercyclical capital or provisioning requirements, including why their impact might be expected to be limited, and concludes with recommendations for developing country officials who want to learn how to make their financial systems less exposed to crises.
    Keywords: Financial crisis, Securitization, Regulation and Supervision, Safety Nets
    JEL: G21 G28 G32
    Date: 2009–12
  12. By: Scott Brave; R. Andrew Butters
    Abstract: By incorporating the Harvey accumulator into the large approximate dynamic factor framework of Doz et al. (2006), we are able to construct a coincident index of financial conditions from a large unbalanced panel of mixed frequency financial indicators. We relate our financial conditions index, or FCI, to the concept of a "financial crisis" using Markov-switching techniques. After demonstrating the ability of the index to capture "crisis" periods in U.S. financial history, we present several policy-geared threshold rules for the FCI using Receiver Operator Characteristics (ROC) curve analysis.
    Keywords: Financial crises ; Financial markets
    Date: 2010

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