nep-rmg New Economics Papers
on Risk Management
Issue of 2013‒11‒29
eighteen papers chosen by
Stan Miles
Thompson Rivers University

  1. There is a VaR Beyond Usual Approximations By Kratz , Marie
  2. The Impact of the Regulation of Centrally Cleared Credit Risk Transfer and Capital Requirements on Banks’ Lending Discipline By Arnold, Marc
  3. Procyclicality and Bank Portfolio Risk Level under a Constant Leverage Ratio By Olivier Bruno; Alexandra Girod
  4. Bailouts and Systemic Insurance By Giovanni Dell'Ariccia; Lev Ratnovski
  5. Modeling Banking, Sovereign, and Macro Risk in a CCA Global VAR By Dale F. Gray
  6. Rules of Thumb for Bank Solvency Stress Testing By Daniel C. Hardy; Christian Schmieder
  7. Identifying and tracking global, EU and Eurozone systemically important banks with public data By Sergio Masciantonio
  8. High moment variations and their application By Geon Ho Choe; Kyungsub Lee
  9. Interest rate risk and the Swiss solvency test By Eder, Armin; Keiler, Sebastian; Pichl, Hannes
  10. Recursive formula for arithmetic Asian option prices By Kyungsub Lee
  11. Shipping Market Financing: Special Features and the Impact of Basel III By Sambracos, Evangelos; Maniati, Marina
  12. Banking Firm and Two-Moment Decision Making By Broll, Udo; Wong, Wing-Keung; Wu, Mojia
  13. Prevention and precaution By Courbage, Christophe; Rey, Béatrice; Treich, Nicolas
  14. The Curious Case of the Yen as a Safe Haven Currency: A Forensic Analysis By Dennis P. J. Botman; Irineu E. Carvalho Filho; Raphael W. Lam
  15. Probabilistic and statistical properties of realized moments and their use in inference, estimation and risk management By Kyungsub Lee
  16. Singapore: Financial System Stability Assessment By International Monetary Fund. Monetary and Capital Markets Department
  17. Sovereign Wealth Funds: Aspects of Governance Structures and Investment Management By Abdullah Al-Hassan; Michael G Papaioannou; Martin Skancke; Cheng Chih Sung
  18. Costa Rica: Fiscal Transparency Assessment By International Monetary Fund. Fiscal Affairs Dept.

  1. By: Kratz , Marie (ESSEC Business School)
    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
    JEL: C10 C53 G12
    Date: 2013–11
  2. By: Arnold, Marc
    Abstract: This article analyzes the impact of the regulatory design of centrally cleared credit risk transfer and capital requirements on a loan originating bank's lending discipline in the primary loan market. Under Basel III, a bank can transfer credit risk via central clearing at favorable regulatory conditions. Credit risk transfer, however, reduces the lending discipline because it allows the bank to profitably grant and hedge a low quality loan. Stricter capital requirements only mitigate this problem if they are combined with a credit risk retention rule for the loan originator. It is shown how the retention rule, the disclosure requirements on the centrally cleared credit risk transfer market, and the capital requirements for hedged and unhedged loan exposures jointly affect a bank's lending discipline.
    JEL: G18 G28
    Date: 2013–05
  3. By: Olivier Bruno (GREDEG CNRS; University of Nice Sophia Antipolis, France); Alexandra Girod (GREDEG CNRS)
    Abstract: We investigate the impact the risk sensitive regulatory ratio may have on banks' risk taking behaviours during the business cycle. We show that the risk sensitivity of capital requirements introduce by Basel II adds either an "equity surplus" or an "equity deficit" on a bank that owns a fixed capital endowment and a constant leverage ratio. Depending on the magnitude of cyclical variations into requirements, the "surplus" may be exploited by the bank to increase its value toward the selection of a riskier asset or the "deficit" may restrict the bank to opt for a less risky asset. Whether the optimal asset risk level swings among classes of risk through the cycle, the risk level of bank's portfolio may increase during economic upturns, or decrease in downturns, leading to a rise in financial fragility or a "fly to quality" phenomenon.
    Keywords: Bank capital, Basel capital accord, risk incentive
    JEL: G11 G28
    Date: 2013–10
  4. By: Giovanni Dell'Ariccia; Lev Ratnovski
    Abstract: We revisit the link between bailouts and bank risk taking. The expectation of government support to failing banks creates moral hazard—increases bank risk taking. However, when a bank’s success depends on both its effort and the overall stability of the banking system, a government’s commitment to shield banks from contagion may increase their incentives to invest prudently and so reduce bank risk taking. This systemic insurance effect will be relatively more important when bailout rents are low and the risk of contagion (upon a bank failure) is high. The optimal policy may then be not to try to avoid bailouts, but to make them “effectiveâ€: associated with lower rents.
    Keywords: Banking crisis;Financial intermediation;Moral hazard;Banking systems;Risk management;Economic models;Bailouts, banking crises, moral hazard, systemic risk, contagion, bank resolution
    Date: 2013–11–12
  5. By: Dale F. Gray
    Abstract: The purpose of this paper is to develop a model framework for the analysis of interactions between banking sector risk, sovereign risk, corporate sector risk, real economic activity, and credit growth for 15 European countries and the United States. It is an integrated macroeconomic systemic risk model framework that draws on the advantages of forward-looking contingent claims analysis (CCA) risk indicators for the banking systems in each country, forward-looking CCA risk indicators for sovereigns, and a GVAR model to combine the banking, the sovereign, and the macro sphere. The CCA indicators capture the nonlinearity of changes in bank assets, equity capital, credit spreads, and default probabilities. They capture the expected losses, spreads and default probability for sovereigns. Key to the framework is that sovereign credit spreads, banking system credit risk, corporate sector credit risk, economic growth, and credit variables are combined in a fully endogenous setting. Upon estimation and calibration of the global model, we simulate various negative and positive shock scenarios, particularly to bank and sovereign risk. The goal is to use this framework to analyze the impact and spillover of shocks and to help identify policies that would mitigate banking system, sovereign credit risk and recession risk—policies including bank capital increases, purchase of sovereign debt, and guarantees.
    Keywords: Banking sector;Credit expansion;Sovereign debt;Credit risk;Cross country analysis;Economic models;contingent claims analysis (CCA), global vector autoregression (GVAR).
    Date: 2013–10–23
  6. By: Daniel C. Hardy; Christian Schmieder
    Abstract: Rules of thumb can be useful in undertaking quick, robust, and readily interpretable bank stress tests. Such rules of thumb are proposed for the behavior of banks’ capital ratios and key drivers thereof—primarily credit losses, income, credit growth, and risk weights—in advanced and emerging economies, under more or less severe stress conditions. The proposed rules imply disproportionate responses to large shocks, and can be used to quantify the cyclical behaviour of capital ratios under various regulatory approaches.
    Keywords: Banks;Banking crisis;Stress testing;Economic models;Stress testing, rules of thumb, bank stability, bank capitalization
    Date: 2013–11–11
  7. By: Sergio Masciantonio (Bank of Italy)
    Abstract: This paper develops a methodology for identifying systemically important financial institutions based on that developed by the Basel Committee on Banking Supervision (2011) and used by the Financial Stability Board in its yearly G-SIBs identification. The methodology uses publicly available data to provide fully transparent results with a G-SIBs list that helps to bridge the gap between market knowledge and supervisory decisions. Moreover, the results include a complete ranking of the banks in the sample, according to their systemic importance scores. The methodology is then applied to EU and Eurozone samples of banks to obtain their systemic importance ranking and SIFI lists. This is one of the first methodologies capable of identifying systemically relevant banks at the European level. A statistical analysis and some geographical and historical evidence provide further insight into the notion of systemic importance, its policy implications and the future applications of this methodology.
    Keywords: banks, balance sheets, systemic risk, SIFIs, financial stability, regulation
    JEL: G01 G10 G18 G20 G21 G28
    Date: 2013–10
  8. By: Geon Ho Choe; Kyungsub Lee
    Abstract: We propose a new method of measuring the third and fourth moments of return distribution based on quadratic variation method when the return process is assumed to have zero drift. The realized third and fourth moments variations computed from high frequency return series are good approximations to corresponding actual moments of the return distribution. An investor holding an asset with skewed or fat-tailed distribution is able to hedge the tail risk by contracting the third or fourth moment swap under which the float leg of realized variation and the predetermined fixed leg are exchanged. Thus constructed portfolio follows more Gaussian-like distribution and hence the investor effectively hedge the tail risk.
    Date: 2013–11
  9. By: Eder, Armin; Keiler, Sebastian; Pichl, Hannes
    Abstract: In this paper, we present a new approach to measuring interest rate risk for insurers within the Swiss Solvency Test, which overcomes the shortcomings of the standard model. The standard model of the Swiss Solvency Test is based on more interest rate risk factors than are actually needed to capture interest rate risk, it allows for significantly negative interest rates and it tends toward procyclical solvency capital requirements. Our new approach treats interest rate risk with direct reference to the underlying term structure model and interprets its parameters as a canonical choice of the relevant interest rate risk factors. In this way, the number of interest rate risk factors is substantially reduced and interest rate risk measurement is linked to the term structure model itself. The consideration of empirical interest rate data and the acceptance of the economical implausibility of persistently negative interest rates significantly below the cost of holding cash motivate the introduction of a truncated Gaussian process to simulate innovation in the future development of the parameters of the underlying term structure model. In a natural way this leads to mean-reverting interest rate behaviour and to countercyclical solvency capital requirements. --
    Keywords: interest rate risk,yield curve,truncated Gaussian process,Swiss Solvency Test
    JEL: C51 C58 G22 G28
    Date: 2013
  10. By: Kyungsub Lee
    Abstract: We derive a recursive formula for arithmetic Asian option prices with finite observation times in semimartingale models. The method is based on the relationship between the risk-neutral expectation of the quadratic variation of the return process and European option prices. The computation of arithmetic Asian option prices is straightforward whenever European option prices are available. Applications with numerical results under the Black-Scholes framework and the exponential L\'evy model are proposed.
    Date: 2013–11
  11. By: Sambracos, Evangelos; Maniati, Marina
    Abstract: Shipping sector constitutes a sector with special characteristics that considerably differentiate it from the other sub-sectors of international transport. The maximisation of benefits for each one of the special market characteristics form a highly dynamic environment, with high risk of loss of invested capital. Within this framework, commercial banks, being the main source of financing shipping market, which is characterised by high capital and operating costs, have to take into account various variables in order to minimise the risk and maximise the return. The last is of particular importance considering the recent regulatory framework for banks applied by the Basel III, which has been elaborated on the grounds of inappropriateness of Basel II.
    Keywords: Finance, Shipping Market, Basel, Risks
    JEL: E32 G15 G32 R40
    Date: 2013–10–01
  12. By: Broll, Udo; Wong, Wing-Keung; Wu, Mojia
    Abstract: The economic environment for financial institutions has become increasingly risky. Hence these institutions must find ways to manage risk of which one of the most important forms is interest rate risk. In this paper we use the mean-variance (mean-standard deviation) approach to examine a banking firm investing in risky assets and hedging opportunities. The mean-standard deviation framework can be used because our hedging model satisfies a scale and location condition. The focus of this study is on how interest rate risk affects optimal bank investment in the loan and deposit market when derivatives are available. Furthermore we explore the relationship among the first- and second-degree stochastic dominance efficient sets and the mean-variance efficient set.
    Keywords: banking firm, investment, technology, risk, derivatives, hedging,(mu,sigma)-preferences, stochastic dominance.
    JEL: G21 G22
    Date: 2013–12–23
  13. By: Courbage, Christophe; Rey, Béatrice; Treich, Nicolas
    Abstract: This chapter surveys the economic literature on prevention and precaution. Prevention refers as either a self-protection activity – i.e. a reduction in the probability of a loss – or a self-insurance activity – i.e. a reduction of the loss –. Precaution is defined as a prudent and temporary activity when the risk is imperfectly known. We first present results on prevention, including the effect of risk preferences, wealth and background risks. Second, we discuss how the concept of precaution is strongly linked to the effect of arrival of information over time in sequential models as well as to situations in which there is ambiguity over probability distributions.
    Date: 2013–10
  14. By: Dennis P. J. Botman; Irineu E. Carvalho Filho; Raphael W. Lam
    Abstract: During risk-off episodes, the yen is a safe haven currency and on average appreciates against the U.S. dollar. We investigate the proximate causes of yen risk-off appreciations. We find that neither capital inflows nor expectations of the future monetary policy stance can explain the yen’s safe haven behavior. In contrast, we find evidence that changes in market participants’ risk perceptions trigger derivatives trading, which in turn lead to changes in the spot exchange rate without capital flows. Specifically, we find that risk-off episodes coincide with forward hedging and reduced net short positions or a buildup of net long positions in yen. These empirical findings suggest that offshore and complex financial transactions should be part of spillover analyses and that the effectiveness of capital flow management measures or monetary policy coordination to address excessive exchange rate volatility might be limited in certain cases.
    Keywords: Currencies;Japan;Exchange rate appreciation;Capital flows;Monetary policy;Risk management;Safe Haven, Yen Volatility, Capital Flows, Derivatives
    Date: 2013–11–06
  15. By: Kyungsub Lee
    Abstract: We study the probabilistic and statistical properties of the variation based realized third and fourth moments of financial returns. The realized moments of the return are unbiased and relative efficient estimators for the actual moments of the return distribution under a martingale condition in the return process. For the estimation of a stochastic volatility model, we employ a simple method of estimation and a generalized method of moments estimation based on the realized second and third moments. Conditional thin tale property of the return distribution with given quadratic variation of the return is discussed. We explain the structure of moments variation swaps and analyze the thin tale property of the portfolio return hedged by the third moment variation swap.
    Date: 2013–11
  16. By: International Monetary Fund. Monetary and Capital Markets Department
    Abstract: EXECUTIVE SUMMARY The Singapore financial system is highly developed, and well regulated and supervised. Singapore is one of the world’s largest financial centers, built around a core of domestic and international banks, and also offers a wide range of non-bank services. The authorities have given strong emphasis to integrity and stability in finance and to compliance with international standards, and have addressed most recommendations made by the 2004 FSAP. Singapore’s current regulation and supervision are among the best globally. The Monetary Authority of Singapore (MAS) oversees the entire financial system, and has the analytical and operational capabilities to do so effectively. Singapore is exposed to a broad array of domestic and global risks, especially in light of its interconnectedness with other financial centers. The most pressing vulnerability appears to stem from the rapid growth of credit and real estate prices in recent years, but the financial system is also exposed to possible spillovers from a future tightening of U.S. monetary policy, an economic slowdown in China, or a deterioration of economic conditions in Europe. The team’s stress tests suggest that these risks are manageable. This reflects banks’ large capital and other cushions, and the decisive macroprudential actions taken by MAS to address the threat of a bubble in the housing sector. Moreover, MAS has sought to address potential spillovers from other major financial centers by converting large retail branches operating in the domestic market into domestically incorporated subsidiaries, and by pressing in international fora for greater sharing of supervisory information on global systemically important financial institutions (G-SIFIs). Looking forward, the analysis suggests the importance of continuing to monitor closely cross-border interbank liabilities, and also of continuing to adjust macroprudential measures in response to domestic housing market conditions.
    Keywords: Financial system stability assessment;Financial sector;Banks;Credit risk;Bank supervision;Insurance;Stress testing;Capital markets;Macroprudential Policy;Singapore;
    Date: 2013–11–14
  17. By: Abdullah Al-Hassan; Michael G Papaioannou; Martin Skancke; Cheng Chih Sung
    Abstract: This paper presents in a systematic (normative) manner the salient features of a SWF‘s governance structure, in relation to its objectives and investment management that can ensure its efficient operation and enhance its financial performance. In this context, it distinguishes among the various governing bodies and analyzes key aspects of the investment policy and setting of the risk tolerance level in order to ensure consistent risk-bearing capacity and greater accountability. Further, it discusses the important role of SWFs in macroeconomic management and the need for close coordination with other macroeconomic and financial policies as well as their role in global financial stability.
    Keywords: Sovereign wealth funds;Asset management;Investment policy;Corporate governance;Transparency;Risk management;sovereign wealth funds, governance structure, investment management, risk management, macroeconomic coordination
    Date: 2013–11–11
  18. By: International Monetary Fund. Fiscal Affairs Dept.
    Abstract: EXECUTIVE SUMMARY One of the most important aspects of good fiscal management is the capacity of government to formulate and communicate fiscal policies. Fundamental to this is the production and publication of fiscal reports which are both timely and complete and written in an accessible language. The same applies with regard to the preparation, approval, and outturn data of the budget. Likewise, the identification and management of fiscal risks has become increasingly important in view of the recent international crises which have demonstrated that part of the risks lay outside the traditional areas of central government attention. The new 2013 Fiscal Transparency Assessment (FTA) Code developed by the Fiscal Affairs Department (FAD) of the International Monetary Fund (IMF) is an instrument that seeks to reveal a country’s fiscal transparency situation and help prevent fiscal crises. The new Fiscal Transparency Code replaces the 1988 Fiscal Transparency ROSC Code, which was updated in 2007. The structure of the previous Code was based on four pillars, namely the (i) clarity of the roles and responsibilities of public institutions, (ii) degree of openness and transparency of budget processes, (iii) availability to the public of fiscal information, and (iv) guarantees regarding the integrity of fiscal information. This Code has served member countries well, having been used as the basis for the Fund’s assessment of 93 countries. The 1998 Code also played an important role in promoting improvements to fiscal standards, institutions, and reporting. The objectives of the new Code are broad. They aim to enable country authorities, international agencies, markets, and the general public to have: (i) a better understanding of the most significant differences or discrepancies in the fiscal data published by governments; (ii) a more comprehensive description of the main risks to governments’ fiscal forecasts, (iii) a clearer picture of how countries’ fiscal information management practices compare with international standards, and (iv) a more specific, sequenced action plan for addressing the main fiscal transparency weaknesses identified. The new fiscal transparency assessment is divided into three pillars. Those are: (i) the presentation of fiscal reports; (ii) the development of fiscal projections and budgets; and (iii) the analysis and management of fiscal risks. Chapters I, II, and III of the report follow this same sequence. The new Code is divided into 38 dimensions. For each dimension, the practice-based situation is evaluated as “BASIC†(yellow), “GOOD†(light green), or “ADVANCED†(dark green). If the practice is not up to the basic assessment, the denomination “LESS THAN BASIC†(red) is adopted. Costa Rica participated in a fiscal transparency ROSC assessment in November 2007 in keeping with the previous version of the Fiscal Transparency Code.
    Keywords: Fiscal transparency;Fiscal policy;Budgets;Budgeting;Fiscal risk;Risk management;Costa Rica;
    Date: 2013–10–30

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