nep-rmg New Economics Papers
on Risk Management
Issue of 2013‒02‒03
fourteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Bank/sovereign risk spillovers in the European debt crisis By V. DE BRUYCKERE; M. GERHARDT; G. SCHEPENS; R. VANDER VENNET
  2. Risk Parity Portfolios with Risk Factors By Roncalli, Thierry; Weisang, Guillaume
  3. Leverage-induced systemic risk under Basle II and other credit risk policies By Sebastian Poledna; Stefan Thurner; J. Doyne Farmer; John Geanakoplos
  4. International Financial Reforms: Capital Standards, Resolution Regimes and Supervisory Colleges, and their Effect on Emerging Markets By Alford, Duncan
  5. Bayesian Credit Ratings (new version) By Paola Cerchiello; Paolo Giudici
  6. Risk Factors and Value at Risk in Publicly Trades Companies of the Nonrenewable Energy Sector By Marcelo Bianconi; Joe A. Yoshino
  7. The minimal confidence levels of Basel capital regulation By Alexander Zimper
  8. Bank Pay Caps, Bank Risk, and Macroprudential Regulation By John Thanassoulis
  9. Pricing Rainfall Derivatives at the CME By Brenda López Cabrera; Martin Odening; Matthias Ritter;
  10. Using Premia and Nsp for Constructing a Risk Management Benchmark for Testing Parallel Architecture By Jean-Philippe Chancelier; Jérôme Lelong; Bernard Lapeyre
  11. DebtRank-transparency: Controlling systemic risk in financial networks By Stefan Thurner; Sebastian Poledna
  12. Predicting the Past: Understanding the Causes of Bank Distress in the Netherlands in the 1920s By Christopher L. Colvin; Abe de Jong; Philip T. Fliers
  13. Bank Regulation and Supervision in 180 Countries from 1999 to 2011 By James R. Barth; Gerard Caprio, Jr.; Ross Levine
  14. Cross-Ownership as a Structural Explanation for Over- and Underestimation of Default Probability By Sabine Karl; Tom Fischer

    Abstract: This paper investigates contagion between bank risk and sovereign risk in Europe over the period 2006-2011. We define contagion as excess correlation, i.e. correlation between banks and sovereigns over and above what is explained by common factors, using CDS spreads at the bank and at the sovereign level. Moreover, we investigate the determinants of contagion by analyzing bank-specific as well as country-specific variables and their interaction. We provide empirical evidence that various contagion channels are at work, including a strong home bias in bank bond portfolios, using the EBA’s disclosure of sovereign exposures of banks. We find that banks with a weak capital and/or funding position are particularly vulnerable to risk spillovers. At the country level, the debt ratio is the most important driver of contagion.
    Keywords: Contagion, bank risk, sovereign risk, bank business models, bank regulation, sovereign debt crisis
    JEL: G01 G21 G28 H6
    Date: 2012–12
  2. By: Roncalli, Thierry; Weisang, Guillaume
    Abstract: Portfolio construction and risk budgeting are the focus of many studies by academics and practitioners. In particular, diversification has spawn much interest and has been defined very differently. In this paper, we analyze a method to achieve portfolio diversification based on the decomposition of the portfolio's risk into risk factor contributions. First, we expose the relationship between risk factor and asset contributions. Secondly, we formulate the diversification problem in terms of risk factors as an optimization program. Finally, we illustrate our methodology with some real life examples and backtests, which are: budgeting the risk of Fama-French equity factors, maximizing the diversification of an hedge fund portfolio and building a strategic asset allocation based on economic factors.
    Keywords: risk parity; risk budgeting; factor model; ERC portfolio; \diversification; concentration; Fama-French model; hedge fund allocation; strategic asset allocation
    JEL: G11 C58 C60
    Date: 2012–09–15
  3. By: Sebastian Poledna; Stefan Thurner; J. Doyne Farmer; John Geanakoplos
    Abstract: We use a simple agent based model of value investors in financial markets to test three credit regulation policies. The first is the unregulated case, which only imposes limits on maximum leverage. The second is Basle II, which also imposes interest rate spreads on loans and haircuts on collateral, and the third is a hypothetical alternative in which banks perfectly hedge all of their leverage-induced risk with options that are paid for by the funds. When compared to the unregulated case both Basle II and the perfect hedge policy reduce the risk of default when leverage is low but increase it when leverage is high. This is because both regulation policies increase the amount of synchronized buying and selling needed to achieve deleveraging, which can destabilize the market. None of these policies are optimal for everyone: Risk neutral investors prefer the unregulated case with a maximum leverage of roughly four, banks prefer the perfect hedge policy, and fund managers prefer the unregulated case with a high maximum leverage. No one prefers Basle II.
    Date: 2013–01
  4. By: Alford, Duncan (Asian Development Bank Institute)
    Abstract: This paper focuses on the relevance to emerging economies of three major financial reforms following the global financial crisis of 2007–2009: (1) the improved capital requirements intended to reduce the risk of bank failure (“Basel III”), (2) the improved recovery and resolution regimes for global banks, and (3) the development of supervisory colleges of cross-border financial institutions to improve supervisory cooperation and convergence. The paper also addresses the implications of these regulatory reforms for Asian emerging markets.
    Keywords: international financial reforms; capital standards; resolution regimes; supervisory colleges; emerging markets
    JEL: G20 G28 O16
    Date: 2013–01–17
  5. By: Paola Cerchiello (Department of Economics and Management, University of Pavia); Paolo Giudici (Department of Economics and Management, University of Pavia)
    Abstract: In this contribution we aim at improving ordinal variable selection in the context of causal models. In this regard, we propose an approach that provides a formal inferential tool to compare the explanatory power of each covariate, and, therefore, to select an effective model for classification purposes. Our proposed model is Bayesian nonparametric, and, thus, keeps the amount of model specification to a minimum. We consider the case in which information from the covariates is at the ordinal level. A noticeable instance of this regards the situation in which ordinal variables result from rankings of companies that are to be evaluated according to different macro and micro economic aspects, leading to ordinal covariates that correspond to various ratings, that entail different magnitudes of the probability of default. For each given covariate, we suggest to partition the statistical units in as many groups as the number of observed levels of the covariate. We then assume individual defaults to be homogeneous within each group and heterogeneous across groups. Our aim is to compare and, therefore, select the partition structures resulting from the consideration of different explanatory covariates. The metric we choose for variable comparison is the calculation of the posterior probability of each partition. The application of our proposal to a European credit risk database shows that it performs well, leading to a coherent and clear method for variable averaging the estimated default probabilities.
    Date: 2013–01
  6. By: Marcelo Bianconi; Joe A. Yoshino
    Abstract: We analyze a sample of 64 oil and gas companies of the nonrenewable energy sector from 26 countries using daily observations on return on stock from July 15, 2003 to August 14, 2012. A panel model with fixed effects and Tarch effects shows significant prices for specific risk factors including company size and debt-to-equity and significant prices for common risk factors including the U.S. Dow Jones market excess return, the Vix, the WTI price of crude oil, and the FX of the euro, Chinese yuan, Brazilian real, Japanese yen, and British pound vis-a-vis the U.S. dollar. The evidence from multivariate Garch-DCC models is that the companies have significant heterogeneity in response to specific and common factors. We show that the financial crisis of 2008 is the period of largest conditional volatility and DCC under exposure to all factors. Comparisons of one-day horizon value at risk show that Garch models without taking into account exposure underestimate value at risk. In accounting for the exposure to all factors, we find that both DCC and value at risk increase considerably during the financial crisis and remain larger in magnitude after the financial crisis of 2008.
    Keywords: Return on stocks, price of risk, value at risk, oil and gas industry, dynamic conditional correlation (DCC)
    JEL: G12 C3 Q3 L72
    Date: 2013
  7. By: Alexander Zimper (Department of Economics, University of Pretoria)
    Abstract: The Basel Committee on Banking Supervision sets the official confidence level at which a bank is supposed to absorb annual losses at 99.9%. However, due to an inconsistency between the notion of expected losses in the Vasicek model, on the one hand, and the practice of Basel regulation, on the other hand, actual confidence levels are likely to be lower. This paper calculates the minimal confidence levels which correspond to a worst case scenario in which a Basel-regulated bank holds capital against unexpected losses only. I argue that the probability of a bank failure is significantly higher than the official 0.1% if, firstly, the bank holds risky loans and if, secondly, the bank was previously affeected by substantial write-offs.
    Keywords: Banking Regulation, Probability of Bank Failure, Definition of Expected Losses, Financial Stability
    JEL: G18 G32
    Date: 2013–01
  8. By: John Thanassoulis
    Abstract: This paper studies the consequences of a regulatory pay cap in proportion to assets onbank risk, bank value, and bank asset allocations. The cap is shown to lower banks' riskand raise banks' values by acting against a competitive externality in the labour market.The risk reduction is achieved without the possibility of reduced lending from a Tier 1increase. The cap encourages diversi cation and reduces the need a bank has to focus ona limited number of asset classes. The cap can be used for Macroprudential Regulationto encourage banks to move resources away from wholesale banking to the retail bankingsector. Such an intervention would be targeted: in 2009 a 20% reduction in remunerationwould have been equivalent to more than 150 basis points of extra tier 1 for UBS, forexample.
    Keywords: Remuneration, compensation, bonuses, capital conservation, systemic bank risk
    JEL: G01 G21 G28 G32
    Date: 2012–12–17
  9. By: Brenda López Cabrera; Martin Odening; Matthias Ritter;
    Abstract: Many business people such as farmers and financial investors are affected by indirect losses caused by scarce or abundant rainfall. Because of the high potential of insuring rainfall risk, the Chicago Mercantile Exchange (CME) began trading rainfall derivatives in 2011. Compared to temperature derivatives, however, pricing rainfall derivatives is more difficult. In this article, we propose to model rainfall indices via a flexible type of distribution, namely the normal-inverse Gaussian distribution, which captures asymmetries and heavy-tail behaviour. The prices of rainfall futures are computed by employing the Esscher transform, a wellknown tool in actuarial science. This approach is flexible enough to price any rainfall contract and to adjust theoretical prices to market prices by using the calibrated market price of risk. This empirical analysis is conducted with U.S. precipitation data and CME futures data providing first results on the market price of risk for rainfall derivatives.
    Keywords: Weather derivatives, precipitation, Esscher transform, market price of risk
    JEL: G19 G29 G22 Q59
    Date: 2013–01
  10. By: Jean-Philippe Chancelier (CERMICS - Centre d'Enseignement et de Recherche en Mathématiques et Calcul Scientifique - Ecole des Ponts ParisTech); Jérôme Lelong (LJK - Laboratoire Jean Kuntzmann - CNRS : UMR5224 - Université Joseph Fourier - Grenoble I - Université Pierre Mendès-France - Grenoble II - Institut Polytechnique de Grenoble - Grenoble Institute of Technology); Bernard Lapeyre (CERMICS - Centre d'Enseignement et de Recherche en Mathématiques et Calcul Scientifique - Ecole des Ponts ParisTech)
    Abstract: Financial institutions have massive computations to carry out overnight which are very demanding in terms of the consumed CPU. The challenge is to price many different products on a cluster-like architecture. We have used the Premia software to valuate the financial derivatives. In this work, we explain how Premia can be embedded into Nsp, a scientific software like Matlab, to provide a powerful tool to valuate a whole portfolio. Finally, we have integrated an MPI toolbox into Nsp to enable to use Premia to solve a bunch of pricing problems on a cluster. This unified framework can then be used to test different parallel architectures.
    Keywords: Premia; Mpi; Nsp
    Date: 2013
  11. By: Stefan Thurner; Sebastian Poledna
    Abstract: Banks in the interbank network can not assess the true risks associated with lending to other banks in the network, unless they have full information on the riskiness of all the other banks. These risks can be estimated by using network metrics (for example DebtRank) of the interbank liability network which is available to Central Banks. With a simple agent based model we show that by increasing transparency by making the DebtRank of individual nodes (banks) visible to all nodes, and by imposing a simple incentive scheme, that reduces interbank borrowing from systemically risky nodes, the systemic risk in the financial network can be drastically reduced. This incentive scheme is an effective regulation mechanism, that does not reduce the efficiency of the financial network, but fosters a more homogeneous distribution of risk within the system in a self-organized critical way. We show that the reduction of systemic risk is to a large extent due to the massive reduction of cascading failures in the transparent system. An implementation of this minimal regulation scheme in real financial networks should be feasible from a technical point of view.
    Date: 2013–01
  12. By: Christopher L. Colvin (Queen’s University Management School, Queen’s University Belfast); Abe de Jong (Rotterdam School of Management, Erasmus University); Philip T. Fliers (Rotterdam School of Management, Erasmus University)
    Abstract: Why do some banks fail in financial crises while others survive? This paper answers this question by analysing the consequences of the Dutch financial crisis of the 1920s for 143 banks, of which 37 failed. Banks’ choices in balance sheet composition, corporate governance practices and shareholder liability regimes were found to have a significant impact on their chances of experiencing distress. Banks bore a higher probability of failing if, on the eve of the crisis, they: were highly performing; were highly leveraged; had fewer interlocking directorates with non-banks; and concentrated their managerial interlocks with highly profitable banks. Banks which chose to adopt shareholder liability regimes with unpaid capital were more likely to experience distress, but could mitigate this risk by keeping higher portions of their equity unpaid. Receiver operating characteristic analysis shows that interlock characteristics in particular have a high predictive power.
    Keywords: financial crises; bank failures; interlocking directorates; shareholder liability; the Netherlands; the interwar period
    JEL: G21 G33 G34 N24
    Date: 2013–01
  13. By: James R. Barth; Gerard Caprio, Jr.; Ross Levine
    Abstract: In this paper and the associated online database, we provide new data and measures of bank regulatory and supervisory policies in 180 countries from 1999 to 2011. The data include and the measures are based upon responses to hundreds of questions, including information on permissible bank activities, capital requirements, the powers of official supervisory agencies, information disclosure requirements, external governance mechanisms, deposit insurance, barriers to entry, and loan provisioning. The dataset also provides information on the organization of regulatory agencies and the size, structure, and performance of banking systems. Since the underlying surveys are large and complex, we construct summary indices of key bank regulatory and supervisory policies to facilitate cross-country comparisons and analyses of changes in banking policies over time.
    JEL: G21 G28 O5
    Date: 2013–01
  14. By: Sabine Karl; Tom Fischer
    Abstract: Based on the work of Suzuki (2002), we consider a generalization of Merton's asset valuation approach (Merton, 1974) in which two firms are linked by cross-ownership of equity and liabilities. Suzuki's results then provide no arbitrage prices of firm values, which are derivatives of exogenous asset values. In contrast to the Merton model, the assumption of lognormally distributed assets does not result in lognormally distributed firm values, which also affects the corresponding probabilities of default. In a simulation study we see that, depending on the type of cross-ownership, the lognormal model can lead to both, over- and underestimation of the actual probability of default of a firm under cross-ownership. In the limit, i.e. if the levels of cross-ownership tend to their maximum possible value, these findings can be shown theoretically as well. Furthermore, we consider the default probability of a firm in general, i.e. without a distributional assumption, and show that the lognormal model is often able to yield only a limited range of probabilities of default, while the actual probabilities may take any value between 0 and 1.
    Date: 2013–01

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