New Economics Papers
on Risk Management
Issue of 2013‒11‒14
eleven papers chosen by

  1. There is a VaR Beyond Usual Approximations By Marie Kratz
  2. Remarks at Panel Discussion on OTC Derivatives Reform and broader financial reforms agenda By William C. Dudley
  3. Incentive compensation for risk managers when effort is unobservable By Paul H. Kupiec
  4. The capital structure and governance of a mortgage securitization utility By Patricia C. Mosser; Joseph Tracy; Joshua Wright
  5. Modelling and measuring business risk and the resiliency of retail banks By Chaffai, Mohamed; Dietsch, Michel
  6. Regulatory-Compliant Derivatives Pricing is Not Risk-Neutral By Chris Kenyon; Andrew Green
  7. The bonsai and the gardener: using flow data to better assess financial sector leverage By Javier Villar Burke
  8. Remarks at the celebration of the 10th anniversary of CLS By Christine M. Cumming
  9. Macro determinants of U.S. stock market risk premia in bull and bear markets By Baetje, Fabian; Menkhoff, Lukas
  10. Risk of financial runs: implications for financial stability By Eric S. Rosengren
  11. Conservative accounting yields excessive risk-taking; a note By Johannes Becker; Melanie Steinhoff

  1. By: Marie Kratz (SID - Information Systems / Decision Sciences Department - ESSEC Business School, MAP5 - Mathématiques appliquées Paris 5 - CNRS : UMR8145 - Université Paris V - Paris Descartes)
    Abstract: Basel II and Solvency 2 both use the Value-at Risk (VaR) as the risk measure to compute the Capital Requirements. In practice, to calibrate the VaR, a normal approximation is often chosen for the unknown distribution of the yearly log returns of financial assets. This is usually justified by the use of the Central Limit Theorem (CLT), when assuming aggregation of independent and identically distributed (iid) observations in the portfolio model. Such a choice of modeling, in particular using light tail distributions, has proven during the crisis of 2008/2009 to be an inadequate approximation when dealing with the presence of extreme returns; as a consequence, it leads to a gross underestimation of the risks. The main objective of our study is to obtain the most accurate evaluations of the aggregated risks distribution and risk measures when working on financial or insurance data under the presence of heavy tail and to provide practical solutions for accurately estimating high quantiles of aggregated risks. We explore a new method, called Normex, to handle this problem numerically as well as theoretically, based on properties of upper order statistics. Normex provides accurate results, only weakly dependent upon the sample size and the tail index. We compare it with existing methods.
    Keywords: Aggregated risk ; (refined) Berry-Esséen Inequality ; (generalized) Central Limit Theorem ; Conditional (Pareto) Distribution ; Conditional (Pareto) Moment ; Convolution ; Expected Short Fall ; Extreme Values ; Financial Data ; High Frequency Data ; Market Risk ; Order Statistics ; Pareto Distribution ; Rate of Convergence ; Risk Measures ; Stable Distribution ; Value-at-Risk
    Date: 2013–11
  2. By: William C. Dudley
    Abstract: Remarks at the 2013 OTC Derivatives Conference, Paris, France.
    Keywords: Over-the-counter markets ; Derivative securities ; Financial market regulatory reform ; Systemic risk ; Financial risk management ; Competition
    Date: 2013
  3. By: Paul H. Kupiec (American Enterprise Institute)
    Abstract: In a financial intermediary, risk managers can expend effort to reduce loan probability of default and loss given default, but effort is unobservable. Incentive compensation (IC) can induce manager effort. When deposit insurance is subsidized, the demand for risk management declines. Regulatory policy should then reinforce incentives to offer risk mangers appropriate IC contracts.
    Keywords: AEI Economic Policy Working Paper Series
    JEL: A G
    Date: 2013–10
  4. By: Patricia C. Mosser; Joseph Tracy; Joshua Wright
    Abstract: We explore the capital structure and governance of a mortgage-insuring securitization utility operating with government reinsurance for systemic or “tail” risk. The structure we propose for the replacement of the GSEs focuses on aligning incentives for appropriate pricing and transfer of mortgage risks across the private sector and between the private sector and the government. We present the justification and mechanics of a vintage-based capital structure, and assess the components of the mortgage guarantee fee, whose size we find is most sensitive to the required capital ratio and the expected return on that capital. We discuss the implications of selling off some of the utility’s mortgage credit risk to the capital markets and how the informational value of such transactions may vary with the level of risk transfer. Finally, we explore how mutualization could address incentive misalignments arising out of securitization and government insurance, as well as how the governance structure for such a financial market utility could be designed.
    Keywords: Mortgage-backed securities ; Government-sponsored enterprises ; Mortgages ; Risk management
    Date: 2013
  5. By: Chaffai, Mohamed; Dietsch, Michel
    Abstract: The recent banking crisis has revealed the existence of strong resiliency factors in the retail banking business model. On average, retail banks suffered less than other financial institutions from unexpected market changes. This paper proposes a new methodology to measure retail banks' business risk, which is defined as the risk of adverse and unexpected changes in banks' profits coming from sudden changes in the banks' activities. This methodology is based on the efficiency frontier methodology, and, more specifically, on the duality property between the directional distance function and the profitfunction. Using the distance function to compute banks' profitability, we take the distance to the frontier of best practices as a measure of profit inefficiency, ie of unexpected losses related to underperformance. In this approach, shifts in the efficiency frontier induced by adverse shocks to banks' volumes serve as a measure of business risk. This measure of profit volatility allows a measurement to be made of the impact of volume changes on banks' profits. This method is applied to a database containing halfyearly regulatory accounting reports over the 1993-2011 period for more than 90 French banks running a retail banking business model. Our results verify a low level of business risk in retail banking, thus confirming the resiliency of the retail banks' business model. --
    Keywords: Bank solvency,Retail Banking,Business Risk,Efficiency Analysis,Profit Frontier
    JEL: G21 D24
    Date: 2013
  6. By: Chris Kenyon; Andrew Green
    Abstract: Regulators clearly believe that derivatives can never be risk free. Regulators have risk preferences and by imposing costly actions on banks they have made derivatives markets incomplete. These actions have idiosyncratic effects, for example the stress period for Market Risk capital is determined at the bank level, not at desk level. Idiosyncratic effects mean that no single measure makes assets and derivatives martingales for all market participants. Hence the market has no risk-neutral measure and Regulatory-compliant derivatives pricing is not risk-neutral. Market participants have idiosyncratic, multiple, risk-neutral measures but the market does not. Practically, we show that derivatives desks leak PnL (profit-and-loss) even with idealized markets providing credit protection contracts and unlimited liquidity facilities (i.e. repos with zero haircuts). This PnL leak means that derivatives desks are inherently risky as they must rely on competitive advantages to price in the costs of their risks. This strictly positive risk level means that Regulatory-required capital must also have strictly positive costs. Hence Regulatory-compliant derivatives markets are incomplete. If we relax our assumptions by permitting haircuts on repos the situation is qualitatively worse because new Regulatory-driven costs (liquidity buffers) enter the picture. These additional funding costs must be met by desks further stressing their business models. One consequence of Regulatory-driven incomplete-market pricing is that the FVA debate is resolved in favor of both sides: academics on principles (pay for risk); and practitioners on practicalities (desks do pay). As a second consequence we identify appropriate exit prices.
    Date: 2013–11
  7. By: Javier Villar Burke
    Abstract: This paper discusses the concept of leverage, its components and how to measure and monitor it. It proposes an innovative approach to assessing leverage based on flows using the concept of a marginal leverage ratio, which reveals the leverage related to new activities, as a valuable supplement to the traditional absolute leverage ratio. The marginal leverage ratio can be used as an early warning tool to signal potential episodes of excessive leverage and to understand if, and how, banks deleverage. Besides capturing the leveraging-deleveraging cycles better than the absolute leverage ratio, the marginal leverage ratio provides an indication of risks that a stable absolute leverage ratio can conceal.
    JEL: G00 G01 G21 G32
    Date: 2013–06
  8. By: Christine M. Cumming
    Abstract: Comments at the 10th Anniversary of CLS, New York City.
    Keywords: Foreign exchange administration ; Banks and banking, Central ; Financial risk management ; Payment systems ; Clearinghouses (Banking) ; Bank failures ; Bretton Woods Agreements Act
    Date: 2013
  9. By: Baetje, Fabian; Menkhoff, Lukas
    Abstract: This research uses macro factors to explain four standard U.S. stock market risk premia, i.e. the market excess return (RM-RF), size (SMB), value (HML), and momentum (WML). We find in-sample predictive power of macro factors, in particular at a one-year horizon. Differentiating between bull and bear market states roughly doubles forecast performance compared to neglecting market states. All four stock market risk premia can be explained with R-squares of 10% to 25%. However, macro factors have limited predictive power in a true out-of-sample setting.
    Keywords: stock market, risk premia, factor analysis, market states
    JEL: G10 G12
    Date: 2013–10
  10. By: Eric S. Rosengren
    Abstract: Remarks by Eric S. Rosengren, President and Chief Executive Officer, Federal Reserve Bank of Boston, at “Building a Financial Structure for a More Stable and Equitable Economy,” the 22nd Annual Hyman P. Minsky Conference on the State of the U.S. and World Economies, The Levy Economics Institute of Bard College and the Ford Foundation, New York, New York, April 17, 2013.
    Keywords: Financial stability ; Global Financial Crisis, 2008-2009 ; Investment banking
    Date: 2013
  11. By: Johannes Becker (University of Münster); Melanie Steinhoff (University of Münster)
    Abstract: We analyse the role of business taxation for corporate risk-taking under different accounting principles. We build a model in which investors have complete information and markets are perfect. A representative risk-neutral firm invests in one unit of an asset choosing from a continuum of assets differing in income and risk properties. The corporate tax base is determined following specific accounting principles (such as mark-to-market, lower-of-cost-or-market and historical cost). We demonstrate that conservative accounting may imply incentives to overinvest in risky assets. If tax loss offset opportunities are less than perfect, the mark-to-market principle penalizes risky investment whereas more conservative accounting leaves the risk choice unaffected.
    Keywords: accounting; risk-taking; business taxation; corporate investment
    JEL: H25 M41 G32
    Date: 2013

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