New Economics Papers
on Risk Management
Issue of 2012‒07‒08
seventeen papers chosen by

  1. CISS - a composite indicator of systemic stress in the financial system By Dániel Holló; Manfred Kremer; Marco Lo Duca
  2. How Liquid Are UK Banks? By Meilin Yan; Maximilian J. B. Hall; Paul Turner
  3. Single and cross-generation natural hedging of longevity and financial risk By Elisa Luciano; Luca Regis; Elena Vigna
  4. Does Modeling Jumps Help? A Comparison of Realized Volatility Models for Risk Prediction By Yin Liao
  5. Evaluation of Different Hedging Strategies for Commodity Price Risks of Industrial Cogeneration Plants By Palzer, Andreas; Westner, Günther; Madlener, Reinhard
  6. Appraising Credit Ratings: Does the CAP Fit Better than the ROC? By Timothy Irwin; R. John Irwin
  7. Liquidity risk, cash-flow constraints and systemic feedbacks By Kapadia, Sujit; Drehmann, Mathias; Elliott, John; Sterne, Gabriel
  8. Do Dynamic Provisions Enhance Bank Solvency and Reduce Credit Procyclicality? A Study of the Chilean Banking System By Jorge A. Chan-Lau
  9. Enhancing Financial Services through Portfolio-Level Disaster Insurance By Collier, Benjamin; Skees, Jerry R.
  10. Modelling Realized Covariances and Returns By Xin Jin; John M. Maheu
  11. Taming SIFIs By Xavier Freixas; Jean-Charles Rochet
  12. Reciprocal Deposits and Incremental Bank Risk By Sherrill Shaffer
  13. Maximizing Utility of Consumption Subject to a Constraint on the Probability of Lifetime Ruin By Erhan Bayraktar; Virginia R. Young
  14. Bank Failure Risk: Different Now? By Sherrill Shaffer
  15. Surging Capital Flows to Emerging Asia: Facts, Impacts, and Responses By Ravi Balakrishnan; Sanjaya Panth; Sylwia Nowak; Yiqun Wu
  16. Internationally correlated jumps By Kuntara Pukthuanthong; Richard Roll
  17. Fiscal Consolidation in Southeastern European Countries: The Role of Budget Institutions By Carla Sateriale; Brian Olden; Sami Yläoutinen; Duncan Last

  1. By: Dániel Holló (Magyar Nemzeti Bank, 1054 Szabadság tér 8/9, 1850 Budapest, Hungary.); Manfred Kremer (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Marco Lo Duca (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)
    Abstract: This paper introduces a new indicator of contemporaneous stress in the financial system named Composite Indicator of Systemic Stress (CISS). Its specific statistical design is shaped according to standard definitions of systemic risk. The main methodological innovation of the CISS is the application of basic portfolio theory to the aggregation of five market-specific subindices created from a total of 15 individual financial stress measures. The aggregation accordingly takes into account the time-varying cross-correlations between the subindices. As a result, the CISS puts relatively more weight on situations in which stress prevails in several market segments at the same time, capturing the idea that financial stress is more systemic and thus more dangerous for the economy as a whole if financial instability spreads more widely across the whole financial system. Applied to euro area data, we determine within a threshold VAR model a systemic crisis-level of the CISS at which financial stress tends to depress real economic activity. JEL Classification: G01, G10, G20, E44.
    Keywords: Financial system, financial stability, systemic risk, financial stress index, macro-financial linkages.
    Date: 2012–03
  2. By: Meilin Yan (School of Business and Economics, Loughborough University, UK); Maximilian J. B. Hall (School of Business and Economics, Loughborough University, UK); Paul Turner (School of Business and Economics, Loughborough University, UK)
    Abstract: This paper uses a relatively new quantitative model for estimating UK banks' liquidity risk. The model is called the Exposure-Based Cash-Flow-at-Risk (CFaR) model, which not only measures a bank's liquidity risk tolerance, but also helps to improve liquidity risk management through the provision of additional risk exposure information. Using data for the period 1997-2010, we provide evidence that there is variable funding pressure across the UK banking industry, which is forecasted to be slightly illiquid with a small amount of expected cash outflow (i.e. £0.06 billion) in 2011. In our sample of the six biggest UK banks, only the HSBC maintains positive CFaR with 95% confidence, which means that there is only a 5% chance that HSBC's cash flow will drop below £0.67 billion by the end of 2011. RBS is expected to face the largest liquidity risk with a 5% chance that the bank will face a cash outflow that year in excess of £40.29 billion. Our estimates also suggest Lloyds TSB's cash flow is the most volatile of the six biggest UK banks, because it has the biggest deviation between its downside cash flow (i.e. CFaR) and expected cash flow.
    Keywords: UK Balance Sheet Analysis, Liquidity Coverage, Net Cash Capital.
    JEL: G01 G21 G28 G32
    Date: 2012–06
  3. By: Elisa Luciano; Luca Regis; Elena Vigna
    Abstract: The paper provides natural hedging strategies among death benefits and annuities written on a single and on different generations. It obtains closed-form Delta and Gamma hedges, in the presence of both longevity and interest rate risk. We present an application to UK data on survivorship and bond dynamics. We first compare longevity and financial risk exposures: Deltas and Gammas for longevity risk are greater in absolute value than the corresponding sensitivities for interest rate risk. We then calculate the optimal hedges, both within and across generations. Our results apply to both asset and asset-liability management.
    Keywords: Longevity risk, Interest rate risk, Delta-Gamma hedging, Natural hedging, Cross-generation hedging.
    JEL: C02 G22 G32
    Date: 2012
  4. By: Yin Liao
    Abstract: Recent literature has focuses on realized volatility models to predict financial risk. This paper studies the benefit of explicitly modeling jumps in this class of models for value at risk (VaR) prediction. Several popular realized volatility models are compared in terms of their VaR forecasting performances through a Monte carlo study and an analysis based on empirical data of eight Chinese stocks. The results suggest that careful modeling of jumps in realized volatility models can largely improve VaR prediction, especially for emerging markets where jumps play a stronger role than those in developed markets.
    JEL: C13 C32 C52 C53 G17
    Date: 2012–06
  5. By: Palzer, Andreas (Fraunhofer Institute for Solar Energy Systems ISE); Westner, Günther (E.ON Energy Projects GmbH); Madlener, Reinhard (E.ON Energy Research Center, Future Energy Consumer Needs and Behavior (FCN))
    Abstract: In this paper we design and evaluate eight different strategies for hedging commodity price risks of industrial cogeneration plants. Price developments are parameterized based on EEX data from 2008-2011. The probability distributions derived are used to determine the value-at-risk (VaR) of the individual strategies, which are in a final step combined in a mean-variance portfolio analysis for determining the most efficient hedging strategy. We find that the strate-gy adopted can have a marked influence on the remaining price risk. Quarter futures are found to be particularly well suited for reducing market price risk. In contrast, spot trading of CO2 certificates is found to be preferable compared to forward market trading. Finally, portfolio optimization shows that a mix of various hedging strategies can further improve the profita-bility of a heat-based cogeneration plant.
    Keywords: Commodity price risk; Cogeneration; Hedging; mean-variance portfolio optimization
    JEL: D22 D81 G11 G32 Q48
    Date: 2012–03
  6. By: Timothy Irwin; R. John Irwin
    Abstract: ROC and CAP analysis are alternative methods for evaluating a wide range of diagnostic systems, including assessments of credit risk. ROC analysis is widely used in many fields, but in finance CAP analysis is more common. We compare the two methods, using as an illustration the ability of the OECD’s country risk ratings to predict whether a country will have a program with the IMF (an indicator of financial distress). ROC and CAP analyses both have the advantage of generating measures of accuracy that are independent of the choice of diagnostic threshold, such as risk rating. ROC analysis has other beneficial features, including theories for fitting models to data and for setting the optimal threshold, that we show could also be incorporated into CAP analysis. But the natural interpretation of the ROC measure of accuracy and the independence of ROC curves from the probability of default are advantages unavailable to CAP analysis.
    Keywords: Credit , Credit risk , Economic models , OECD ,
    Date: 2012–05–14
  7. By: Kapadia, Sujit (Bank of England); Drehmann, Mathias (Bank for International Settlements); Elliott, John (Bank of England); Sterne, Gabriel (Exotix)
    Abstract: The endogenous evolution of liquidity risk is a key driver of financial crises. This paper models liquidity feedbacks in a quantitative model of systemic risk. The model incorporates a number of channels important in the current financial crisis. As banks lose access to longer-term funding markets, their liabilities become increasingly short term, further undermining confidence. Stressed banks’ defensive actions include liquidity hoarding and asset fire sales. This behaviour can trigger funding problems at other banks and may ultimately cause them to fail. In presenting results, we analyse scenarios in which these channels of contagion operate, and conduct illustrative simulations to show how liquidity feedbacks may markedly amplify distress.
    Keywords: Systemic risk; funding liquidity risk; contagion; stress testing
    JEL: G01 G21 G32
    Date: 2012–06–21
  8. By: Jorge A. Chan-Lau
    Abstract: Dynamic provisions could help to enhance the solvency of individual banks and reduce procyclicality. Accomplishing these objectives depends on country-specific features of the banking system, business practices, and the calibration of the dynamic provisions scheme. In the case of Chile, a simulation analysis suggests Spanish dynamic provisions would improve banks' resilience to adverse shocks but would not reduce procyclicality. To address the latter, other countercyclical measures should be considered.
    Keywords: Banks , Business cycles , Capital , Financial risk ,
    Date: 2012–05–14
  9. By: Collier, Benjamin; Skees, Jerry R.
    Abstract: Financial intermediaries [FIs] in developing and emerging economies are poorly equipped to manage natural disasters. These events create losses for FIs, eroding capital reserves and compromising their ability to lend. Portfolio-level insurance against disasters can improve FI management of these events. We model microfinance intermediaries [MFIs] exposed to severe El Niño in Peru that can now insure against this disaster risk. Our analyses suggest that insurance allows these lenders to manage this risk more efficiently and effectively. These risk management improvements can translate into better financial performance, expansion of banking service outreach, lower interest rates, and reduced volatility in access to credit. Based on these analyses, a large MFI in Peru with which we collaborated is now managing its disaster risk using El Niño insurance.
    Keywords: Financial Economics, Public Economics,
    Date: 2012–08
  10. By: Xin Jin (Department of Economics, University of Toronto, Canada); John M. Maheu (Department of Economics, University of Toronto, Canada; RCEA, Italy)
    Abstract: This paper proposes new dynamic component models of returns and realized covariance (RCOV) matrices based on time-varying Wishart distributions. Bayesian estimation and model comparison is conducted with a range of multivariate GARCH models and existing RCOV models from the literature. The main method of model comparison consists of a term-structure of density forecasts of returns for multiple forecast horizons. The new joint return-RCOV models provide superior density forecasts for returns from forecast horizons of 1 day to 3 months ahead as well as improved point forecasts for realized covariances. Global minimum variance portfolio selection is improved for forecast horizons up to 3 weeks out.
    Keywords: Wishart distribution, predictive likelihoods, density forecasts, realized covariance targeting, MCMC
    JEL: C11 C32 C53 G17
    Date: 2012–06
  11. By: Xavier Freixas; Jean-Charles Rochet
    Abstract: We model a Systemically Important Financial Institution (SIFI) that is too big (or too interconnected) to fail. Without credible regulation and strong supervision, the shareholders of this institution might deliberately let its managers take excessive risk. We propose a solution to this problem, showing how insurance against systemic shocks can be provided without generating moral hazard. The solution involves levying a systemic tax needed to cover the costs of future crises and more importantly establishing a Systemic Risk Authority endowed with special resolution powers, including the control of bankers' compensation packages during crisis periods.
    Keywords: SIFI, dynamic moral hazard, risk taking
    JEL: G21 G32 G34
    Date: 2012–06
  12. By: Sherrill Shaffer
    Abstract: Even after controlling for other observable factors, reciprocal deposits are associated with higher bank risk as measured by the probability of failure and the Zscore. These results are consistent with the moral hazard hypothesis and reject the risk substitution hypothesis.
    JEL: G21
    Date: 2012–06
  13. By: Erhan Bayraktar; Virginia R. Young
    Abstract: In this note, we explicitly solve the problem of maximizing utility of consumption (until the minimum of bankruptcy and the time of death) with a constraint on the probability of lifetime ruin, which can be interpreted as a risk measure on the whole path of the wealth process.
    Date: 2012–06
  14. By: Sherrill Shaffer
    Abstract: Motivated by the debate over similarities between the current and previous financial crises, logit estimates reveal significantly changed linkages between observable financial ratios and probabilities of subsequent bank failure using U.S. data from the 1980s and 2008.
    JEL: G21
    Date: 2012–06
  15. By: Ravi Balakrishnan; Sanjaya Panth; Sylwia Nowak; Yiqun Wu
    Abstract: Net capital flows to emerging Asia rebounded at a record pace following the global financial crisis, raising concerns about overheating and financial stability. This paper documents the size and composition of the most recent surge to Asian emerging markets from a historical perspective and compares developments in the broader economy, asset prices, and corporate variables across the different episodes of strong inflows. We find little evidence of a significant build-up of imbalances and resource misallocation during the most recent surge. We also review country experiences in managing the risks associated with inflows and argue that Asian countries have used regulatory measures during past surges, although there is not strong evidence of their efficacy without supporting monetary and fiscal policies.
    Keywords: Asia , Capital flows , Capital inflows , Cross country analysis , Emerging markets , Fiscal risk , Risk management , Stabilization measures ,
    Date: 2012–05–22
  16. By: Kuntara Pukthuanthong (San Diego State University, 5500 Campanile Drive, San Diego CA 92182, USA.); Richard Roll (UCLA Anderson 110 Westwood Plaza Los Angeles, CA 90095.)
    Abstract: Stock returns are characterized by extreme observations, jumps that would not occur under the smooth variation of a Gaussian process. We find that jumps are prevalent in most countries. This has been little investigation of whether the jumps are internationally correlated. Their possible inter-correlation is important for investors because international diversification is less effective when jumps are frequent, unpredictable and strongly correlated. Public supervisors may also mind about widely correlated jumps, as they could bring down certain financial intermediaries. We investigate using daily returns on broad equity indexes from 82 countries and for several statistical measures of jumps. Various jump measures are not in complete agreement but a general pattern emerges. Jumps are internationally correlated but not as much as returns. Although the smooth variation in returns is driven strongly by systematic global factors, jumps are more idiosyncratic and most of them are found in Europe. Some pairs of correlated jumps occur simultaneously but not to the extent of correlated returns. JEL Classification: G11, G15
    Keywords: Diversification; Jumps; correlation
    Date: 2012–05
  17. By: Carla Sateriale; Brian Olden; Sami Yläoutinen; Duncan Last
    Abstract: This paper assesses the relative strengths and weaknesses of fiscal institutions in ten Southeastern European countries, using recent benchmarking methodologies developed by FAD. The assessment evaluates each country’s understanding of the scale of the fiscal adjustment challenge, its ability to develop a credible consolidation strategy, and its capacity to implement the strategy. Key institutional arrangements, are generally in place, including top-down budgeting and medium-term budget frameworks. Other institutional arrangements require further attention, including macro-fiscal forecasting, fiscal risk analysis, setting fiscal objectives, presence and role of independent fiscal agencies, and top-down parliamentary approval.
    Keywords: Budgeting , Budgets , Cross country analysis , Eastern Europe , Fiscal consolidation , Fiscal policy , Fiscal risk , Risk management ,
    Date: 2012–05–07

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