New Economics Papers
on Risk Management
Issue of 2011‒08‒22
ten papers chosen by

  1. BASEL III: responses to consultative documents, vital aspects of the consultative processes and the journey culminating in the present framework (Part 1) By Ojo, Marianne
  2. Capital Regulation and Tail Risk By Perotti, Enrico C; Ratnovski, Lev; Vlahu, Razvan
  3. Estimating the risk-adjusted capital is an affair in the tails By Canestraro, Davide; Dacorogna, Michel
  4. Macro-economy in models for default probability. By Geurdes, Han / J.F.
  5. Country Insurance Using Financial Instruments By Marcos Chamon; Yuanyan Sophia Zhang; Luca Antonio Ricci
  6. Possible Unintended Consequences of Basel III and Solvency II By Gregorio Impavido; Ahmed I Al-Darwish; Michael Hafeman; Malcolm Kemp; Padraic O'Malley
  7. Systemic Risk Exposures: A 10-by-10-by-10 Approach By Darrell Duffie
  8. Policy Instruments To Lean Against The Wind In Latin America By Mercedes Garcia-Escribano; Man-Keung Tang; Carlos I. Medeiros; W. Christopher Walker; Carlos Fernandez Valdovinos; Camilo E Tovar Mora; Mercedes Vera-Martin; Jorge A. Chan Lau; G. Terrier; Rodrigo O. Valdés
  9. A Network Model of Financial System Resilience By Kartik Anand; Prasanna Gai; Sujit Kapadia; Simon Brennan; Matthew Willison
  10. Are Corporate Default Probabilities Consistent with the Static Tradeoff Theory? By Armen Hovakimian; Ayla Kayhan; Sheridan Titman

  1. By: Ojo, Marianne
    Abstract: This paper is aimed at providing a comprehensive overview of, and responses to, four very vital components of the consultative processes which have contributed to the new framework known as Basel III. The paper will approach these components in the order of the consultative processes, namely, the capital proposals, the liquidity proposals and the Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability. The capital proposals comprise proposals aimed at strengthening the resilience of the banking sector, the proposal relating to international framework for liquidity risk measurement, standards and monitoring and, the countercyclical capital buffer proposal. Whilst the capital proposals have been welcomed, there has been growing realisation since the aftermath of the recent Financial Crises that banks which have been complying with capital adequacy requirements could still face severe liquidity problems. As well as highlighting the importance of introducing counter cyclical capital buffers, the response to the countercyclical proposal draws attention to the need for greater focus on more forward looking provisions, as well as provisions which are aimed at addressing losses and unforeseen problems attributed to “maturity transformation of short-term deposits into long term loans.” The Basel Committee’s consultative document on the “Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non Viability” sets out a proposal aimed at “enhancing the entry criteria of regulatory capital to ensure that all regulatory capital instruments issued by banks are capable of absorbing losses in the event that a bank is unable to support itself in the private market.” Amongst other issues addressed, the response to the consultative document highlights why the controlled winding down procedure also constitutes a means whereby losses could still be absorbed in the event that a bank is unable to support itself in the private market.
    Keywords: Counter cyclical buffers; liquidity risks; pro cyclicality; loan loss provisions; financial crises; bank; regulation; capital; insolvency; financial crises; moral hazard; Basel III
    JEL: K2 G21 E3
    Date: 2010–10
  2. By: Perotti, Enrico C; Ratnovski, Lev; Vlahu, Razvan
    Abstract: The paper studies risk mitigation associated with capital regulation, in a context where banks may choose tail risk assets. We show that this undermines the traditional result that higher capital reduces excess risk-taking driven by limited liability. Moreover, higher capital may have an unintended e¤ect of enabling banks to take more tail risk without the fear of breaching the minimal capital ratio in nontail risky project realizations. The results are consistent with stylized facts about pre-crisis bank behavior, and suggest implications for the optimal design of capital regulation.
    Keywords: Capital regulation; Keywords: Banking; Risk; Risk-taking; Systemic risk; Tail risk
    JEL: G21 G28
    Date: 2011–08
  3. By: Canestraro, Davide; Dacorogna, Michel
    Abstract: (Re)insurance companies need to model their liabilities' portfolio to compute the risk-adjusted capital (RAC) needed to support their business. The RAC depends on both the distribution and the dependence functions that are applied among the risks in a portfolio. We investigate the impact of those assumptions on an important concept for (re)insurance industries: the diversification gain. Several copulas are considered in order to focus on the role of dependencies. To be consistent with the frameworks of both Solvency II and the Swiss Solvency Test, we deal with two risk measures: the Value-at-Risk and the expected shortfall. We highlight the behavior of different capital allocation principles according to the dependence assumptions and the choice of the risk measure.
    Keywords: Capital Allocation; Copula; Dependence; Diversification Gain; Model Uncertainty; Monte Carlo Methods; Risk-Adjusted Capital; Risk Measure
    JEL: C10 G11 C15
    Date: 2010–11–05
  4. By: Geurdes, Han / J.F.
    Abstract: We inspect the question how to adapt to macro-economical variables those probability of default (PD) estimates where Merton's model assumptions cannot be used. The need for this is to obtain trustworthy estimates of PD from a given economical situation. The structure of a known market-credit risk model is adapted. The key concept in this adaptation is the assumption of a different probabilistic situation for a firm before and at (first) default. If a corporate firm defaults we use a different probabilistic relation between macro-economical and market risk than in a firm's normal not default operation. We found a remarkable resemblance between relativity of physical space-time and the economical framework of variables. This means a solution of the calibration problem without using a Gaussian distribution estimates of the default probability.
    Keywords: English
    JEL: C65 G32 C01 C60
    Date: 2011–07–28
  5. By: Marcos Chamon; Yuanyan Sophia Zhang; Luca Antonio Ricci
    Abstract: The availability of financial instruments related to indices that track global financial conditions and risk appetite can potentially offer countries alternative options to insure against external shocks. This paper shows that while these instruments can explain much of the in-sample variation in borrowing spreads, this fails to materialize in hedging strategies that work well out-of-sample during tranquil times. However, positions on instruments such as those tracking the US High Yield Spread, the VIX, and especially other emerging market CDS spreads can substantially offset adverse movements in own spreads during times of systemic crises. Moreover, high risk countries seem to gain more, as their underlying weaknesses makes them more vulnerable to external shocks. Overall, the limited value in tranquil times, coupled with political economy arguments and innovation costs could justify the limited interest for this type of hedging in practice
    Keywords: Cross country analysis , Economic models , Emerging markets , External shocks , Financial instruments , Insurance , Risk management ,
    Date: 2011–07–15
  6. By: Gregorio Impavido; Ahmed I Al-Darwish; Michael Hafeman; Malcolm Kemp; Padraic O'Malley
    Abstract: In today’s financial system, complex financial institutions are connected through an opaque network of financial exposures. These connections contribute to financial deepening and greater savings allocation efficiency, but are also unstable channels of contagion. Basel III and Solvency II should improve the stability of these connections, but could have unintended consequences for cost of capital, funding patterns, interconnectedness, and risk migration.
    Date: 2011–08–05
  7. By: Darrell Duffie
    Abstract: Here, I present and discuss a “10-by-10-by-10” network-based approach to monitoring systemic financial risk. Under this approach, a regulator would analyze the exposures of a core group of systemically important financial firms to a list of stressful scenarios, say 10 in number. For each scenario, about 10 such designated firms would report their gains or losses. Each reporting firm would also provide the identities of the 10, say, counterparties with whom the gain or loss for that scenario is the greatest in magnitude relative to all counterparties. The gains or losses with each of those 10 counterparties would also be reported, scenario by scenario. Gains and losses would be measured in terms of market value and also in terms of cash flow, allowing regulators to assess risk magnitudes in terms of stresses to both economic values and also liquidity. Exposures would be measured before and after collateralization. One of the scenarios would be the failure of a counterparty. The “top ten” counterparties for this scenario would therefore be those whose defaults cause the greatest losses to the reporting firm. In eventual practice, the number of reporting firms, the number of stress scenarios, and the number of major counterparties could all exceed 10, but it is reasonable to start with a small reporting system until the approach is better understood and agreed upon internationally.
    JEL: G28 G32
    Date: 2011–08
  8. By: Mercedes Garcia-Escribano; Man-Keung Tang; Carlos I. Medeiros; W. Christopher Walker; Carlos Fernandez Valdovinos; Camilo E Tovar Mora; Mercedes Vera-Martin; Jorge A. Chan Lau; G. Terrier; Rodrigo O. Valdés
    Abstract: This paper reviews policy tools that have been used and/or are available for policy makers in the region to lean against the wind and review relevant country experiences using them. The instruments examined include: (i) capital requirements, dynamic provisioning, and leverage ratios; (ii) liquidity requirements; (iii) debt-to-income ratios; (iv) loan-to-value ratios; (v) reserve requirements on bank liabilities (deposits and nondeposits); (vi) instruments to manage and limit systemic foreign exchange risk; and, finally, (vii) reserve requirements or taxes on capital inflows. Although the instruments analyzed are mainly microprudential in nature, appropriately calibrated over the financial cycle they may serve for macroprudential purposes.
    Keywords: Banking sector , Capital controls , Capital flows , Credit risk , Cross country analysis , Fiscal policy , Foreign exchange , Latin America , Liquidity , Monetary policy , Risk management ,
    Date: 2011–07–11
  9. By: Kartik Anand; Prasanna Gai; Sujit Kapadia; Simon Brennan; Matthew Willison
    Abstract: We examine the role of macroeconomic fluctuations, asset market liquidity, and network structure in determining contagion and aggregate losses in a financial system. Systemic instability is explored in a financial network comprising three distinct, but interconnected, sets of agents – domestic banks, international financial institutions, and firms. Calibrating the model to advanced country banking sector data, we obtain sensible aggregate loss distributions which are bimodal in nature. We demonstrate how systemic crises may occur and analyze how our results are influenced by firesale externalities and the feedback effects from curtailed lending in the macroeconomy. We also illustrate the resilience of our model financial system to stress scenarios with sharply rising corporate default rates and falling asset prices.
    Keywords: Contagion, Financial crises, Network models, Systemic risk
    JEL: C63 G21
    Date: 2011–08
  10. By: Armen Hovakimian; Ayla Kayhan; Sheridan Titman
    Abstract: Default probability plays a central role in the static tradeoff theory of capital structure. We directly test this theory by regressing the probability of default on proxies for costs and benefits of debt. Contrary to predictions of the theory, firms with higher bankruptcy costs, i.e., smaller firms and firms with lower asset tangibility, choose capital structures with higher bankruptcy risk. Further analysis suggests that the capital structures of smaller firms with lower asset tangibility, which tend to have less access to capital markets, are more sensitive to negative profitability and equity value shocks, making them more susceptible to bankruptcy risk.
    JEL: G3 G33
    Date: 2011–08

General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.