New Economics Papers
on Risk Management
Issue of 2011‒01‒03
sixteen papers chosen by

  1. Bank Capital: Lessons from the Financial Crisis By Ouarda Merrouche; Enrica Detragiache; Asli Demirgüç-Kunt
  2. Credit allocation, capital requirements and output By Jokivuolle, Esa; Kiema, Ilkka; Vesala, Timo
  3. REALIZED VOLATILITY RISK By David E. Allen; Michael McAleer; Marcel Scharth
  4. Marking Systemic Portfolio Risk with Application to the Correlation Skew of Equity Baskets By Alex Langnau; Daniel Cangemi
  5. The Role of the State in Managing and Forestalling Systemic Financial Crises By Adams, Charles
  6. Preparing for Basel IV: why liquidity risks still present a challenge to regulators in prudential supervision By Ojo, Marianne
  7. Contagion Between European and US Banks: Evidence from Equity Prices By Daniel Fricke
  8. Into the Great Unknown: Stress Testing with Weak Data By Li L. Ong; Rodolfo Maino; Nombulelo Duma
  9. Do specialization benefits outweigh concentration risks in credit portfolios of German banks? By Böve, Rolf; Düllmann, Klaus; Pfingsten, Andreas
  10. Probabilistic Forecasts of Volatility and its Risk Premia By Worapree Maneesoonthorn; Gael M. Martin; Catherine S. Forbes; Simone Grose
  11. Carry Trade with Maintained Currencies - A Risk and Return Analysis for the Egyptian Pound By Christian Kalhoefer; Sara Shenouda; Ahmed Badawi
  12. Hedging with CO2 allowances: the ECX market By Carlos Pinho; Mara Madaleno
  13. Managing Public Debt and Its Financial Stability Implications By Jay Surti; Faisal Ahmed; Michael G Papaioannou; Guilherme Pedras; Udaibir S. Das
  14. Monetary Policy, Leverage, and Bank Risk-Taking By Luc Laeven; Giovanni Dell'Ariccia; Robert Marquez
  15. Stress testing banks' profitability: the case of French banks By Coffinet, J.; Lin, S.
  16. Financial Innovation and Risk, The Role of Information By Roberto Piazza

  1. By: Ouarda Merrouche; Enrica Detragiache; Asli Demirgüç-Kunt
    Abstract: Using a multi-country panel of banks, we study whether better capitalized banks experienced higher stock returns during the financial crisis. We differentiate among various types of capital ratios: the Basel risk-adjusted ratio; the leverage ratio; the Tier I and Tier II ratios; and the tangible equity ratio. We find several results: (i) before the crisis, differences in capital did not have much impact on stock returns; (ii) during the crisis, a stronger capital position was associated with better stock market performance, most markedly for larger banks; (iii) the relationship between stock returns and capital is stronger when capital is measured by the leverage ratio rather than the risk-adjusted capital ratio; (iv) higher quality forms of capital, such as Tier 1 capital and tangible common equity, were more relevant.
    Keywords: Bank regulations , Banks , Capital , Cross country analysis , Economic models , Financial crisis , Global Financial Crisis 2008-2009 , Risk management , Stock markets ,
    Date: 2010–12–10
  2. By: Jokivuolle, Esa (Bank of Finland Research); Kiema, Ilkka (University of Helsinki); Vesala, Timo (Danske Bank A/S, Finland)
    Abstract: We show how banks’ excessive risk-taking, stemming from informational asymmetries in loan markets, can lead to an excessive output loss when a recession starts. Risk-based capital requirements can alleviate the output loss by reducing excessive risk-taking in ‘normal’ times. Model simulations suggest that the differentiation of risk-weights in the Basel framework might be further increased in order to take full advantage of the allocational effects of capital requirements. Our analysis also provides a new rationale for the countercyclical elements of capital requirements.
    Keywords: bank regulation; Basel III; capital requirements; credit risk; crises; procyclicality
    JEL: D41 D82 G14 G21 G28
    Date: 2010–12–01
  3. By: David E. Allen (School of Accounting, Finance and Economics, Edith Cowan University); Michael McAleer (Erasmus University Rotterdam, Tinbergen Institute, The Netherlands, and Institute of Economic Research, Kyoto University); Marcel Scharth (Tinbergen Institute, The Netherlands, Department of Econometrics, VU University Amsterdam)
    Abstract: In this paper we show that realized variation measures constructed from high- frequency returns reveal a large degree of volatility risk in stock and index returns, where we characterize volatility risk by the extent to which forecasting errors in realized volatility are substantive. Even though returns standardized by ex post quadratic variation measures are nearly Gaussian, this unpredictability brings greater uncertainty to the empirically relevant ex ante distribution of returns. Explicitly modeling this volatility risk is fundamental. We propose a dually asymmetric realized volatility model, which incorporates the fact that realized volatility series are systematically more volatile in high volatility periods. Returns in this framework display time varying volatility, skewness and kurtosis. We provide a detailed account of the empirical advantages of the model using data on the S&P 500 index and eight other indexes and stocks.
    Keywords: Realized volatility, volatility of volatility, volatility risk, value-at-risk, forecasting, conditional heteroskedasticity.
    Date: 2010–12
  4. By: Alex Langnau; Daniel Cangemi
    Abstract: The downside risk of a portfolio of (equity)assets is generally substantially higher than the downside risk of its components. In particular in times of crises when assets tend to have high correlation, the understanding of this difference can be crucial in managing systemic risk of a portfolio. In this paper we generalize Merton's option formula in the presence jumps to the multi-asset case. It is shown how common jumps across assets provide an intuitive and powerful tool to describe systemic risk that is consistent with data. The methodology provides a new way to mark and risk-manage systemic risk of portfolios in a systematic way.
    Date: 2010–12
  5. By: Adams, Charles
    Abstract: This paper reviews recent state interventions in financial crises and draws lessons for crisis management. A number of areas are identified where crisis management could be strengthened, including with regard to the tools and instruments used to involve the private sector in crisis resolution (with a view to reducing the recent enhanced role of official bailouts and the associated moral hazard), to allow for the orderly resolution of systemically important financial firms (to make these firms “safe to fail”), and with regard to achieving better integration with ex ante macroprudential surveillance. The paper proposes the establishment of high level systemic risk councils (SRCs) in each country with responsibility for overseeing systemic risk in both tranquil times and crisis periods and coordinating the activities of key government ministries, agencies, and the central bank.
    Date: 2010–08
  6. By: Ojo, Marianne
    Abstract: This paper considers and assesses various explanations attributed as principal factors of the recent Financial Crisis. In particular, it focuses on two principal regulatory tools which constitute the basis of the framework promulgated by recent Basel Committee's initiatives, that is, Basel III. These two regulatory tools being capital and liquidity requirements. Various conclusions have been put forward to explain what triggered the recent Financial Crisis. This paper aims to explain why the Basel Committee's liquidity requirements and present proposals aimed at addressing liquidity risks, still represent a very modest milestone in efforts aimed at addressing challenges in prudential regulation and supervision. Even though problems attributed to capital adequacy requirements are considered by many authorities to have triggered the recent Crisis, the paper will highlight how runs on banks are triggered by liquidity crises and that liquidity risks cannot be isolated from systemic risks. In so doing, it will incorporate the roles assumed by information asymmetries and market based regulation – hence elaborate on how market based regulation could serve to address problems which trigger liquidity risks. Imperfect knowledge being a factor which is contributory to liquidity crises and bank runs, and market based regulation being essential in facilitating disclosure - since the Basel Committee's focus on banks and prudential supervision cannot on its own, address the challenges encountered in the present regulatory environment. Furthermore, it will address measures and proposals which could serve as bases for future regulatory reforms - as well as criticisms and challenges still encountered by recent Basel Committee initiatives.
    Keywords: capital; liquidity; Basel III; Basel Committee; lender of last resort; banks; insurance; securities; information asymmetry; market based regulation; bail outs; disclosure; moral hazard; Dodd Frank Act; Financial Crisis
    JEL: K2 E52 D8
    Date: 2010–12–22
  7. By: Daniel Fricke
    Abstract: This paper employs an Extreme Value Theory framework to investigate the existence of contagion between European and US banks. The fact that many regulators have no detailed data sets about interbank cross-exposures raises the necessity of finding market-based indicators in order to analyze the effects of crises and to quantify the risk of contagion. The Distance-to-default (DD) measure is being employed as an indicator of banks' soundness. Focusing on the negative tail of the daily percentage changes of the DD, a country-specific indicator variable labeled "Coexceedances" is built measuring the number of banks simultaneously experiencing a large shock on a given day. Based on a multinomial logit model, for each country the probability of observing several banks in the tail is estimated. Controlling for common factors and including foreign countries' lagged coexceedances allows to interpret significant coefficients of foreign lagged coexceedances as contagion. The main finding is that there is significant bi-lateral contagion between European and US banks. Furthermore the existence of contagion between European banks is verified by the underlying data set
    Keywords: Banking, Contagion, Distance-to-default, Multinomial logit
    JEL: F36 G15 G21
    Date: 2010–12
  8. By: Li L. Ong; Rodolfo Maino; Nombulelo Duma
    Abstract: Stress testing has become the risk management tool du jour in the wake of the global financial crisis. In countries where the information reported by financial institutions is considered to be of sufficiently good quality, and supervisory and regulatory standards are high, stress tests can be of significant value. In contrast, the proliferation of stress testing in underdeveloped financial systems with weak oversight regimes is fraught with uncertainties, as it is unclear what the results actually represent and how they could be usefully applied. In this paper, problems associated with stress tests using weak data are examined. We offer a potentially more useful alternative, the "breaking point" method, which also requires close coordination with on-site supervision and complemented by other supervisory tools and qualitative information. Excel spreadsheet templates of the stress tests presented in this paper are provided.
    Keywords: Bank supervision , Banks , Data quality assessment framework , Financial institutions , Risk management ,
    Date: 2010–12–08
  9. By: Böve, Rolf; Düllmann, Klaus; Pfingsten, Andreas
    Abstract: Lending specialization on certain industry sectors can have opposing effects on monitoring (including screening) abilities and on the sectoral concentration risk of a credit portfolio. In this paper, we examine in the first part if monitoring abilities of German cooperative banks and savings banks increase with their specialization on certain industry sectors. We observe that sectoral specialization generally entails better monitoring quality, particularly in the case of the cooperative banks. In the second part we measure the overall effect of better monitoring and the associated higher sectoral credit concentrations on the credit risk of the portfolio. Our empirical results suggest that specialization benefits overcompensate the impact of higher credit concentrations in the case of the cooperative banks. For savings banks, the results on the net effect depend on how specialization is measured. If specialization is gauged by Hirschman Herfindahl indices, the net effect is an increase of portfolio risk due to the higher sectoral concentration. If specialization is instead measured by distance measures, portfolio risk decreases as the impact of better monitoring abilities prevails. --
    Keywords: bank lending,loan portfolio,diversification,expected loss,savings banks,cooperative banks,concentration,economic capital,credit risk
    JEL: G11 G21
    Date: 2010
  10. By: Worapree Maneesoonthorn; Gael M. Martin; Catherine S. Forbes; Simone Grose
    Abstract: The object of this paper is to produce distributional forecasts of physical volatility and its associated risk premia using a non-Gaussian, non-linear state space approach. Option and spot market information on the unobserved variance process is captured by using dual 'model-free' variance measures to define a bivariate observation equation in the state space model. The premium for diffusive variance risk is defined as linear in the latent variance (in the usual fashion) whilst the premium for jump variance risk is specified as a conditionally deterministic dynamic process, driven by a function of past measurements. The inferential approach adopted is Bayesian, implemented via a Markov chain Monte Carlo algorithm that caters for the multiple sources of non-linearity in the model and the bivariate measure. The method is applied to empirical spot and option price data for the S&P500 index over the 1999 to 2008 period, with conclusions drawn about investors' required compensation for variance risk during the recent financial turmoil. The accuracy of the probabilistic forecasts of the observable variance measures is demonstrated, and compared with that of forecasts yielded by more standard time series models. To illustrate the benefits of the approach, the posterior distribution is augmented by information on daily returns to produce Value at Risk predictions, as well as being used to yield forecasts of the prices of derivatives on volatility itself. Linking the variance risk premia to the risk aversion parameter in a representative agent model, probabilistic forecasts of relative risk aversion are also produced.
    Keywords: Volatility Forecasting; Non-linear State Space Models; Non-parametric Variance Measures; Bayesian Markov Chain Monte Carlo; VIX Futures; Risk Aversion.
    JEL: C11 C53
    Date: 2010–12–20
  11. By: Christian Kalhoefer (Faculty of Management Technology, The German University in Cairo); Sara Shenouda (Faculty of Management Technology, The German University in Cairo); Ahmed Badawi (Faculty of Management Technology, The German University in Cairo)
    Abstract: The forward premium puzzle in the exchange rate market, resulting from the deviation and failure of interest rate parity, has awakened the interest of speculators to perform carry trade activities. Across literature the main risk associated and measured for carry trade has been the exchange rate risk and crash risk related to the relevant currencies used. But within the literature, the influence of maintained currencies on the carry trade results has not yet been covered. This paper analyzes the potential performance and the risk of carry trade strategies within a maintained exchange rate regime. For this analysis an empirical study of carry trade strategies applied between the EGP and other currencies has been used and compared to those with the USD as an example for a maintained exchange rate. Our risk and return analysis clearly shows a combination of high return and low risk for the maintained currency carry trade.
    Keywords: Carry Trade Performance, Uncovered Interest Parity, Maintained Exchange Rates, Value at Risk
    JEL: F31 G15
    Date: 2010–12
  12. By: Carlos Pinho (Departamento de Economia e Gestão Industrial, Universidade de Aveiro, GOVCOPP); Mara Madaleno (Departamento de Economia e Gestão Industrial, Universidade de Aveiro, GOVCOPP)
    Abstract: We investigate and empirically estimate optimal hedge ratios, for the first time, in the EU ETS carbon market. Minimum variance hedge ratios are conditionally estimated with multivariate GARCH models, and unconditionally by OLS and the naïve strategy for the European Climate Exchange (ECX) market in the period 2005-2009. Also, utility gains are considered in order to take into account risk-return considerations. Empirical results indicate that dynamic hedging provides superior gains (in reducing the variance portfolio) compared to those obtained from static hedging, when adjustment costs are not taken into account. Moreover, results improve when the leptokurtic characteristics of the data are into consideration through distributions. Results are always compared in and out of sample, suggesting also that utility gains increase with investor's increased preference over risk.
    Keywords: CO2 Emission Allowances; Dynamic Hedging; Futures Prices; Risk Management; Spot Prices
    JEL: C32 G19 G32 Q54
    Date: 2010–12
  13. By: Jay Surti; Faisal Ahmed; Michael G Papaioannou; Guilherme Pedras; Udaibir S. Das
    Abstract: This paper explores the relationship between the level and management of public debt and financial stability, and explains the channels through which the two are interlinked. It suggests that the broader implications of a debt management strategy and its implementation should be carefully analyzed by debt managers and policy makers in terms of their impact on the government’s balance sheet, macroeconomic developments, and the financial system.
    Keywords: Capital markets , Debt management , Debt strategy , Financial instruments , Financial stability , Public debt , Risk management , Sovereign debt ,
    Date: 2010–12–06
  14. By: Luc Laeven; Giovanni Dell'Ariccia; Robert Marquez
    Abstract: We provide a theoretical foundation for the claim that prolonged periods of easy monetary conditions increase bank risk taking. The net effect of a monetary policy change on bank monitoring (an inverse measure of risk taking) depends on the balance of three forces: interest rate pass-through, risk shifting, and leverage. When banks can adjust their capital structures, a monetary easing leads to greater leverage and lower monitoring. However, if a bank's capital structure is fixed, the balance depends on the degree of bank capitalization: when facing a policy rate cut, well capitalized banks decrease monitoring, while highly levered banks increase it. Further, the balance of these effects depends on the structure and contestability of the banking industry, and is therefore likely to vary across countries and over time.
    Keywords: Banks , Capital , Central bank policy , Credit risk , Economic models , Financial intermediation , Monetary policy , Risk management ,
    Date: 2010–12–03
  15. By: Coffinet, J.; Lin, S.
    Abstract: We build a stress testing framework to evaluate the sensitivity of banks’ profitability to plausible but severe adverse macroeconomic shocks. Specifically, we test the resilience of French banks using supervisory data over the period 1993-2009. First, we identify the macroeconomic and financial variables (GDP growth, interest rate maturity spread, stock market’s volatility) and bank-specific variables (size, capital ratio, ratio of non interest income to assets) that significantly affect French banks’ profitability. Second, our macroeconomic stress testing exercises based on a simulation of macroeconomic variables show that French banks’ profitability is resilient to major adverse macroeconomic scenarios. Specifically, our findings highlight that even severe recessions would leave the French banking system profitable.
    Keywords: bank profitability, dynamic panel estimation, stress test.
    JEL: C23 G21 L2
    Date: 2010
  16. By: Roberto Piazza
    Abstract: Financial innovation has increased diversification opportunities and lowered investment costs, but has not reduced the relative cost of active (informed) investment strategies relative to passive (less informed) strategies. What are the consequences? I study an economy with linear production technologies, some more risky than others. Investors can use low quality public information or collect high quality, but costly, private information. Information helps avoiding excessively risky investments. Financial innovation lowers the incentives for private information collection and deteriorates public information: the economy invests more often in excessively risky technologies. This changes the business cycle properties and can reduce welfare by increasing the likelihood of "liquidation crises"
    Keywords: Business cycles , Data collection , Economic models , Financial risk , Information technology , Investment , Risk management , Securities markets , United States ,
    Date: 2010–11–22

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