nep-rmg New Economics Papers
on Risk Management
Issue of 2011‒12‒19
nine papers chosen by
Stan Miles
Thompson Rivers University

  1. Estimating financial risk using piecewise Gaussian processes By I. Garcia; J. Jimenez
  2. Modeling Correlated Systemic Liquidity and Solvency Risks in a Financial Environment with Incomplete Information By Liliana Schumacher; Theodore M. Barnhill
  3. Systemically Important Banks and Capital Regulation Challenges By Patrick Slovik
  4. Conditional Probabilities and Contagion Measures for Euro Area Sovereign Default Risk By Xin Zhang; Bernd Schwaab; Andre Lucas
  5. Credit Growth and Capital Buffers: Empirical Evidence from Central and Eastern European Countries By Adam Gersl; Jakub Seidler
  6. The Joint Dynamics of Equity Market Factors By Peter Christoffersen; Hugues Langlois
  7. International Diversification During the Financial Crisis: A Blessing for Equity Investors? By Robert Vermeulen
  8. A Model of Liquidity Hoarding and Term Premia in Inter-Bank Markets By Acharya, Viral V.; Skeie, David
  9. Options introduction and volatility in the EU ETS By Julien Chevallier; Yannick Le Pen; Benoît Sévi

  1. By: I. Garcia; J. Jimenez
    Abstract: We present a computational method for measuring financial risk by estimating the Value at Risk and Expected Shortfall from financial series. We have made two assumptions: First, that the predictive distributions of the values of an asset are conditioned by information on the way in which the variable evolves from similar conditions, and secondly, that the underlying random processes can be described using piecewise Gaussian processes. The performance of the method was evaluated by using it to estimate VaR and ES for a daily data series taken from the S&P500 index and applying a backtesting procedure recommended by the Basel Committee on Banking Supervision. The results indicated a satisfactory performance.
    Date: 2011–12
  2. By: Liliana Schumacher; Theodore M. Barnhill
    Abstract: This paper proposes and demonstrates a methodology for modeling correlated systemic solvency and liquidity risks for a banking system. Using a forward looking simulation of many risk factors applied to detailed balance sheets for a 10 bank stylized United States banking system, we analyze correlated market and credit risk and estimate the probability that multiple banks will fail or experience liquidity runs simultaneously. Significant systemic risk factors are shown to include financial and economic environment regime shifts to stressful conditions, poor initial loan credit quality, loan portfolio sector and regional concentrations, bank creditors’ sensitivity to and uncertainties regarding solvency risk, and inadequate capital. Systemic banking system solvency risk is driven by the correlated defaults of many borrowers, other market risks, and inter-bank defaults. Liquidity runs are modeled as a response to elevated solvency risk and uncertainties and are shown to increase correlated bank failures. Potential bank funding outflows and contractions in lending with significant real economic impacts are estimated. Increases in equity capital levels needed to reduce bank solvency and liquidity risk levels to a target confidence level are also estimated to range from 3 percent to 20 percent of assets. For a future environment that replicates the 1987-2006 volatilities and correlations, we find only a small risk of U.S. bank failures focused on thinly capitalized and regionally concentrated smaller banks. For the 2007-2010 financial environment calibration we find substantially elevated solvency and liquidity risks for all banks and the banking system.
    Keywords: Banking systems , Credit risk , Economic models , External shocks , Liquidity , United States ,
    Date: 2011–11–14
  3. By: Patrick Slovik
    Abstract: Bank regulation might have contributed to or even reinforced adverse systemic shocks that materialised during the financial crisis. Capital regulation based on risk-weighted assets encourages innovation designed to circumvent regulatory requirements and shifts banks’ focus away from their core economic functions. Tighter capital requirements based on risk-weighted assets may further contribute to these skewed incentives. The estimated macroeconomic costs of redirecting banks’ attention away from such unconventional business practices are low. During a medium-term adjustment period, for each percentage point of bank equity, regulation that is not based on risk-weighted assets would affect annual GDP growth by -0.02 percentage point more than under the risk-weighted assets framework. Refocusing banks’ attention toward their main economic functions is a core requirement for durable financial stability and sustainable economic growth.<P>Banques d'importance systémique: défis pour la réglementation du capital<BR>La réglementation bancaire pourrait avoir contribué, voire renforcé, des chocs systémiques qui se sont matérialisés lors de la crise financière. La réglementation des fonds propres fondée sur des actifs pondérés par les risques encourage l'innovation conçue pour contourner les exigences réglementaires et éloigne les préoccupations des banques de leurs principales fonctions économiques. Le resserrement des exigences en capital fondées sur les actifs pondérés du risque peut exacerber ce biais d’incitation. Des estimations suggèrent que rediriger l’activité des banques hors de telles pratiques commerciales nonconventionnelles ne serait guère coûteux. Pendant une période d'ajustement de moyen terme, pour chaque point de pourcentage du ratio de capitaux propres bancaires, une réglementation qui ne s’appuie pas sur les actifs pondérés du risque réduirait la croissance annuelle du PIB de seulement 0,02 point de pourcentage de plus qu’une réglementation fondée sur les actifs pondérés par les risques. Un recentrage de l’attention des banques vers leurs principales fonctions économiques est une exigence fondamentale pour garantir la stabilité financière et une croissance économique durables.
    Keywords: financial regulation, financial stability, Basel accord, Basel III, capital requirements, systemically important financial institutions, Too-big-to-fail, Bank Leverage, réglementation financière, crise financière, stabilité financière, Accord de Bâle, Bâle III, institutions financières d'importance systémique, levier bancaire
    JEL: G01 G21 G28
    Date: 2011–12–12
  4. By: Xin Zhang (VU University Amsterdam); Bernd Schwaab (European Central Bank); Andre Lucas (VU University Amsterdam)
    Abstract: The Eurozone debt crisis raises the issue of measuring and monitoring interconnected sovereign credit risk. We propose a novel empirical framework to assess the likelihood of joint and conditional failure for Euro Area sovereigns. Our model captures all the salient features of the data, including skewed and heavy-tailed changes in the price of CDS protection against sovereign default, as well as dynamic volatilities and correlations to ensure that failure dependence can increase in times of stress. We apply the model to Euro Area sovereign CDS spreads from 2008 to mid-2011. Our results reveal significant time-variation in risk dependence and considerable spill-over effects in the likelihood of sovereign failures. We further demonstrate the importance of capturing higher-order time-varying moments during times of crisis for the assessment of dependent risks.
    Keywords: sovereign credit risk; higher order moments; financial stability surveillance
    JEL: C32 G32
    Date: 2011–12–13
  5. By: Adam Gersl; Jakub Seidler
    Abstract: Excessive credit growth is often considered to be an indicator of future problems in the financial sector. This paper examines the issue of how to determine whether the observed level of private sector credit is excessive in the context of the “countercyclical capital bufferâ€, a macroprudential tool proposed in the new regulatory framework of Basel III by the Basel Committee on Banking Supervision. An empirical analysis of selected Central and Eastern European countries, including the Czech Republic, provides alternative estimates of excessive private credit and shows that the HP filter calculation proposed by the Basel Committee is not necessarily a suitable indicator of excessive credit growth for converging countries.
    Keywords: Basel regulation, credit growth, financial crisis countercyclical buffer.
    JEL: G01 G18 G21
    Date: 2011–11
  6. By: Peter Christoffersen (University of Toronto - Rotman School of Management and CREATES); Hugues Langlois (McGill University - Desautels Faculty of Management)
    Abstract: The four equity market factors from Fama and French (1993) and Carhart (1997) are perva- sive in academic empirical asset pricing studies and in applied portfolio allocation. However, the joint distributional dynamics of the factors are rarely studied. For investors basing strate- gies on the factors or using them to model the returns of a wider set of assets, proper risk management requires knowing the joint factor dynamics which we model. We ?nd striking ev- idence of asymmetric tail dependence across the factors. While the linear factor correlations are small and even negative, the extreme correlations are large and positive, so that the linear correlations drastically overstate the bene?ts of diversi?cation across the factors. We model the nonlinear factor dependence and explore its economic importance in a portfolio allocation experiment which shows that signi?cant economic value is earned when acknowledging the nonlinear dependence.
    Keywords: Factors, threshold correlation, copulas, portfolio optimization, asymmetry.
    JEL: C01 G11
    Date: 2011–09–09
  7. By: Robert Vermeulen
    Abstract: This paper empirically investigates international equity investors’ foreign portfolios before and during the financial crisis by estimating a gravity model for 22 source and 42 destination countries. The results show that international stock market diversification provides large gains during the financial crisis. This is remarkable because of large stock market correlations. During the financial crisis investors have larger positions in foreign stock markets which are relatively less correlated with the domestic market. However, this relationship is not present before the crisis. Results at the country level show that aggregate portfolio volatility is lower and returns are higher for investors from low home biased source countries during the financial crisis. This result implies that global equity diversification has an important positive effect on stabilizing a country’s aggregate equity wealth, especially during periods of stock market stress.
    Keywords: international portfolio choice; financial integration; stock market comovement
    JEL: F41 G11 G15
    Date: 2011–12
  8. By: Acharya, Viral V.; Skeie, David
    Abstract: Financial crises are associated with reduced volumes and extreme levels of rates for term inter-bank transactions, such as in one-month and three-month LIBOR markets. We provide an explanation of such stress in term lending by modelling leveraged banks’ precautionary demand for liquidity. When adverse asset shocks materialize, a bank’s ability to roll over debt is impaired because of agency problems associated with high leverage. In turn, a bank’s propensity to hoard liquidity is increasing, or conversely its willingness to provide term lending is decreasing, in its rollover risk over the term of the loan. High levels of short-term leverage and illiquidity of assets can thus lead to low volumes and high rates for term borrowing, even for banks with profitable lending opportunities. In extremis, there can be a complete freeze in inter-bank markets.
    Keywords: bank liquidity; bank loans; debt; financial leverage; interbank market; risk management
    JEL: E43 G01 G21
    Date: 2011–12
  9. By: Julien Chevallier (Université Paris Dauphine); Yannick Le Pen (Université Paris Dauphine); Benoît Sévi (Université de la Méditerranée Aix-Marseille II)
    Abstract: To improve risk management in the European Union Emissions Trading Scheme (EU ETS), the European Climate Exchange (ECX) has introduced option instruments in October 2006. The central question we address is: can we identify a potential destabilizing effect of the introduction of options on the underlying market (EUA futures)? Indeed, the literature on commodities futures suggest that the introduction of derivatives may either decrease (due to more market depth) or increase (due to more speculation) volatility. As the identification of these effects ultimately remains an empirical question, we use daily data from April 2005 to April 2008 to document volatility behavior in the EU ETS. By instrumenting various GARCH models, endogenous break tests, and rolling window estimations, our results overall suggest that the introduction of the option market had the effect of decreasing the level of volatility in the EU ETS while impacting its dynamics. These findings are fairly robust to other likely influences linked to energy and commodity markets.
    Keywords: EU ETS, option prices, volatility, GARCH, rolling estimation, endogenous structural break detection
    JEL: G13 G18 Q57 Q58
    Date: 2011–06

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