nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒02‒02
eighteen papers chosen by
Stan Miles
Thompson Rivers University

  1. The Foster-Hart Measure of Riskiness for General Gambles By Hellmann, Tobias; Riedel, Frank
  2. Model Risk - an Agency Theoretic Approach By Schlegel, Friederike; Hakenes, Hendrik
  3. Occupy Risk Weighting: How the Minimum Leverage Ratio dominates Capital Requirements - A Swiss Example By Kellermann, Kersten; Schlag, Carsten
  4. Interconnected risk contributions: an heavy-tail approach to analyse US financial sectors By M. Bernardi; L. Petrella
  5. A PCA Approach to Common Risk Exposures in the Chilean Banking System By Diego Avanzini; Alejandro Jara
  6. Stress testing at the Magyar Nemzeti Bank By Ádám Banai; Zsuzsanna Hosszú; Gyöngyi Körmendi; Sándor Sóvágó; Róbert Szegedi
  7. The light and dark side of TARP By Uhde, Andre; Farruggio, Christian; Michalak, Tobias C.
  8. Textbook Estimators of Multiperiod Optimal Hedging Ratios: Methodological Aspects and Application to the European Wheat Market By Gianluca Stefani; Marco Tiberti
  9. Idiosyncratic risk and the cost of capital: The case of electricity networks By Schober, Dominik; Schäffler, Stephan; Weber, Christoph
  10. Flood insurance in England – an assessment of the current and newly proposed insurance scheme in the context of rising flood risk By Swenja Surminski; Jillian Eldridge
  11. Value-at-risk Predictions of Precious Metals with Long Memory Volatility Models By Demiralay, Sercan; Ulusoy, Veysel
  12. Risk Sensitivity of Banks, Interbank Markets and the Effects of Liquidity Regulation By Pausch, Thilo
  13. Alarm System for Credit Losses Impairment By Yahia Salhi; Pierre-Emmanuel Thérond
  14. Implications of Bank Regulation for Credit Intermediation and Bank Stability: A Dynamic Perspective By Bucher, Monika; Dietrich, Diemo; Hauck, Achim
  15. Market Timing, Maturity Mismatch, and Risk Management: Evidence from the Banking Industry By Ruprecht, Benedikt; Entrop, Oliver; Kick, Thomas; Wilkens, Marco
  16. Convertible Debt and Shareholder Incentives By Christian Dorion; Pascal François; Gunnar Grass; Alexandre Jeanneret
  17. Leverage and Risk Taking under Moral Hazard By Hott, Christian
  18. Regulatory competition in credit markets with capital standards as signals By Maier, Ulf; Haufler, Andreas

  1. By: Hellmann, Tobias; Riedel, Frank
    Abstract: Foster and Hart proposed an operational measure of riskiness for discrete random variables. We show that their defining equation has no solution for many common continuous distributions. We show how to extend consistently the definition of riskiness to continuous random variables. For many continuous random variables, the risk measure is equal to the worst-case risk measure, i.e. the maximal possible loss incurred by that gamble. We also extend the Foster-Hart risk measure to dynamic environments for general distributions and probability spaces, and we show that the extended measure avoids bankruptcy in infinitely repeated gambles. --
    JEL: D81 G11 D80
    Date: 2013
  2. By: Schlegel, Friederike; Hakenes, Hendrik
    Abstract: In the recent financial crisis, risk management tools have been proven inadequate. Model risk, a key component of bank risk, has shown its negative impact. It seems that risk models did not cover the included risks comprehensively and were not kept up-to-date by banks, and also rating agencies. Consequently, in the aftermath of the crisis banks must adjust their models to reduce model risk. We discuss if banks undertake enough effort to improve their risk models. Furthermore, the paper deals with the optimal organizational structure of this improvement process. We take a close look at risk models of banks and discuss if banks generally invest enough effort to improve their risk models. The question of risk model innovation is analyzed from a managerial as well as from a welfare perspective in the context of a principal agent model - where the bank has to incentivize an agent to perform innovative improvement in the risk model technology. --
    JEL: G01 G21 L22
    Date: 2013
  3. By: Kellermann, Kersten; Schlag, Carsten
    Abstract: In September 2009, G20 representatives called for introducing a minimum leverage ratio as an instrument of financial regulation. It is supposed to assure a certain degree of core capital for banks, independent of the controversial procedures used to assess risk. This paper discusses the interaction and tensions between the leverage ratio and risk-based capital requirements, using financial data of the Swiss systemically important bank UBS. It can be shown that the leverage ratio potentially undermines risk weighting such that banks feel encouraged to take greater risks. The paper proposes an alternative instrument that is conceived as a base risk weight and functions as a backstop. It ensures a minimum core capital ratio, based on unweighted total exposure by ensuring a minimum ratio of risk-weighted to total assets for all banks. The proposed measure is easy to compute like the leverage ratio, and also like the latter, it is independent of risk weighting. Yet, its primary advantage is that it does not supersede risk-based capital adequacy targets, but rather supplements them. --
    JEL: G28 G21 G01
    Date: 2013
  4. By: M. Bernardi; L. Petrella
    Abstract: In this paper we consider a multivariate model-based approach to measure the dynamic evolution of tail risk interdependence among US banks, financial services and insurance sectors. To deeply investigate the risk contribution of insurers we consider separately life and non-life companies. To achieve this goal we apply the multivariate student-t Markov Switching model and the Multiple-CoVaR (CoES) risk measures introduced in Bernardi et. al. (2013b) to account for both the known stylised characteristics of the data and the contemporaneous joint distress events affecting financial sectors. Our empirical investigation finds that banks appear to be the major source of risk for all the remaining sectors, followed by the financial services and the insurance sectors, showing that insurance sector significantly contributes as well to the overall risk. Moreover, we find that the role of each sector in contributing to other sectors distress evolves over time accordingly to the current predominant financial condition, implying different interconnection strength.
    Date: 2014–01
  5. By: Diego Avanzini; Alejandro Jara
    Abstract: This paper studies three related aspects of the Chilean banking’s systemic risk: (i) to what extent the degree of common risk exposure in the Chilean banking system has changed over the past decades, (ii) during which periods this exposure increased the most, and (iii) when this degree of commonality became a systemic concern. Additionally, it identifies systemically important financial institutions in Chile based on their contribution to the degree of common risk exposure. It finds that prior to the 2008-09 global financial crisis the degree of common risk exposure in Chile increased significantly, and that the banks that contributed the most were not necessarily the biggest ones in size, as measured by their assets share.
    Date: 2013–12
  6. By: Ádám Banai (Magyar Nemzeti Bank (the central bank of Hungary)); Zsuzsanna Hosszú (Magyar Nemzeti Bank (the central bank of Hungary)); Gyöngyi Körmendi (Magyar Nemzeti Bank (the central bank of Hungary)); Sándor Sóvágó (Tinbergen Institute (MPhil student)); Róbert Szegedi (Magyar Nemzeti Bank (the central bank of Hungary))
    Abstract: Our study presents the top-down stress testing framework currently used by the Magyar Nemzeti Bank. We run separate solvency and liquidity stress tests to analyse the ability of the banking system to absorb shocks and we present their results in our Report on Financial Stability. In the former, we focus mostly on credit risk but also take into account losses due to market risks. Our study explains in detail the method we apply to quantify the impact of a negative two-year macroeconomic shock on the capital adequacy ratio. We explain the models we use for calculating profit before loan losses, PDs and LGD. We also demonstrate how we measure the impact of an intensive 30-day liquidity shock on the banking system. Finally, we use the stress test completed in the spring of 2013 to explain in detail how the results should be interpreted and what conclusions we can draw from them.
    Keywords: stress test, liquidity risk, credit risk
    JEL: E44 E47 G21
    Date: 2014
  7. By: Uhde, Andre; Farruggio, Christian; Michalak, Tobias C.
    Abstract: This paper empirically investigates the impact of the first announcement of TARP, the announcement of revised TARP, respective capital infusions under TARP-CPP and capital repayments on changes in shareholder value and the risk exposure of supported U.S. banks. Our analysis reveals a light and a dark side of TARP. While announcements as well as capital repayments may provoke positive wealth effects and a decrease in bank risk, equity capital injections to banks are observed to be a severe impediment to restore market confidence and financial stability. Furthermore, while TARP announcements and capital injections may increase systemic risk, no significant effect on systemic risk is found for capital repayments. --
    JEL: G14 G21 G28
    Date: 2013
  8. By: Gianluca Stefani (Dipartimento di Scienza per l'Economia e l'Impresa); Marco Tiberti (Dipartimento di Scienza per l'Economia e l'Impresa)
    Abstract: This work deals with methodological and empirical issues related to multiperiod optimal hedging OLS estimators. We propose an analytical formula for the multiperiod minimum variance hedging ratio starting from the triangular representation of a cointegrated system DGP. Since estimating the hedge ratio matching the frequency of data with the hedging horizon leads to a sample size reduction problem, we carry out a Monte Carlo study to investigate the pattern and hedging efficiency of OLS hedging ratio based on overlapping vs non-overlapping observations exploring a range of hedging horizons and sample sizes. Finally, we applied our approach to real data for a cross hedging related to soft wheat.
    Keywords: Future prices, Hedging, Monte Carlo, Soft wheat
    JEL: C58 G13
    Date: 2013
  9. By: Schober, Dominik; Schäffler, Stephan; Weber, Christoph
    Abstract: We analyze the treatment and impact of idiosyncratic or firm-specific risk in regulation. Regulatory authorities regularly ignore firm-specific characteristics, such as size or asset ages, implying different risk exposure in incentive regulation. In contrast, it is common to apply only a single benchmark, the weighted average cost of capital (WACC), uniformly to all firms. This will lead to implicit discrimination. We combine models of firm-specific risk, liquidity management and regulatory rate setting to investigate impacts on capital costs. We focus on the example of the impact of component failures for electricity network operators. In a simulation model for Germany, we find that capital costs increase by approximately 0.2 to 3.0 percentage points depending on the size of the firm (in the range of 3% to 40% of total cost of capital). Regulation of monopolistic bottlenecks should take these risks into account to avoid implicit discrimination. --
    Keywords: Idiosyncratic/firm-specific risk,discrimination,incentive-based and quality regulation,liquidity management,size effects,electricity networks
    JEL: G32 G33 L51 L94
    Date: 2014
  10. By: Swenja Surminski; Jillian Eldridge
    Abstract: Flooding is the largest natural disaster risk in England and it is expected to rise even further as we experience a changing climate and continue putting more people and property in harm’s way. Managing this growing flood risk requires a broad portfolio of measures to reduce the probability of flooding, keep impact and damages to a minimum and provide financial support for the residual risk. Agreeing on how we pay for this now and in the future is a challenge, with competing drivers such as fairness, economic efficiency, political feasibility and public acceptance all playing their part. One example for this is the recent debate about the future of flood insurance. After more than two years of negotiations between government and the private insurance industry, details of a new scheme (Flood Re) have now been published, with the aim for implementation in summer 2015. While rising flood losses and increasing costs of insurance are the two main reasons for reforming the existing insurance arrangements, one important aspect has been widely neglected: how the existing arrangement and new flood insurance proposal reflect on the need to manage rising flood risks. We investigate this in the context of the assumption that insurance can support and trigger risk reduction behaviour if correctly designed and implemented. We ask if and how the existing and the proposed scheme contain incentives for risk reduction or whether they will increase moral hazard. By applying our analytical framework we find an absence of formal incentive mechanisms in the existing, and in the newly proposed Flood Re scheme. We highlight some of the barriers for applying insurance to risk reduction and point to some possible modifications in the Flood Re proposal to deliver a greater link between risk transfer and risk reduction. Our investigation offers some insights into the challenges of designing and implementing flood insurance schemes – a task that is currently being considered in a range of countries, including several developing countries, who hope to apply flood insurance as a tool to increase their climate resilience.
    Date: 2014–01
  11. By: Demiralay, Sercan; Ulusoy, Veysel
    Abstract: In this paper, we investigate the value-at-risk predictions of four major precious metals (gold, silver, platinum, and palladium) with long memory volatility models, namely FIGARCH, FIAPARCH and HYGARCH, under normal and student-t innovations’ distributions. For these analyses, we consider both long and short trading positions. Overall, our results reveal that long memory volatility models under student-t distribution perform well in forecasting a one-day-ahead VaR for both long and short positions. In addition, we find that FIAPARCH model with student-t distribution, which jointly captures long memory and asymmetry, as well as fat-tails, outperforms other models in VaR forecasting. Our results have potential implications for portfolio managers, producers, and policy makers.
    Keywords: Long memory, value-at-risk, volatility modeling, precious metals prices
    JEL: C53 C58 G17
    Date: 2014–01–27
  12. By: Pausch, Thilo
    Abstract: The industrial organization approach to banking is extended to analyze the effects of interbank market activity and regulatory liquidity requirements on bank behavior. A multi-stage decision situation allows for considering the interaction between credit risk and liquidity risk of banks. This interaction is found to make a risk neutral bank behave as if it were risk averse in an environment where there is no interbank market and liquidity regulation. Introducing a buoyant interbank money market destroys endogenous risk aversion and allows banks to manage credit risk and liquidity risk independently. The paper shows that a liquidity regulation just like the one proposed in BCBS (2010) is not generally able to offset the separating effect of interbank money markets and recreate endogenous risk aversion of banks. --
    JEL: G21 G28 G32
    Date: 2013
  13. By: Yahia Salhi (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429); Pierre-Emmanuel Thérond (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429)
    Abstract: The recent fi nancial crisis has lead the IASB to settle new reporting standards for fi nancial instruments. The extended ability to measure some debt instruments at amortized cost is associated with a new impairment losses mechanism: Expected Credit Losses. In this paper, after a brief description of the principles elaborated by IASB for IFRS 9, we propose a methodology using CDS market prices in order to monitor signi cant changes in creditworthiness of fi nancial instruments and subsequent credit losses impairment. This methodology is implemented in detail to a real world dataset. Numerical tests are drawn to assess the eff ectiveness of the procedure.
    Keywords: Credit Risk; Default; Detection; Monitoring; Impairment; Accounting; IFRS; Insurance; CDS
    Date: 2014–01–13
  14. By: Bucher, Monika; Dietrich, Diemo; Hauck, Achim
    Abstract: Business cycles imply liquidity risks for banks. This paper explores how these risks influence bank lending over the cycle. With forward-looking banks, lending cycles, credit booms and busts, or suppressed and highly fragile bank systems can emerge, depending on the magnitude of liquidity risks. In this context, regulatory stability-enhancing measures have some unpleasant effects on bank lending. Imposing countercyclical capital adequacy ratio may amplify procyclicality or result in disintermediation, when liquidity risks are only moderate and financial stability is barely a threat. Adopting a regulatory margin call eliminates failures but stops lending for larger liquidity risks whereas a liquidity ratio might be a way to reduce risk-taking without fully hampering credit intermediation. --
    JEL: G28 G21 E32
    Date: 2013
  15. By: Ruprecht, Benedikt; Entrop, Oliver; Kick, Thomas; Wilkens, Marco
    Abstract: We investigate financial intermediaries interest rate risk management as the simultaneous decision of on-balance-sheet exposure and interest rate swap use. Our findings show that both decisions are substitute risk management strategies. Hausman exogeneity tests indicate that both decisions are only endogenous to one another for banks that start using swaps for the first time. For other banks, the maturity gap is exogenous to the decision to use swaps, but the reverse relationship is endogenous. For banks with trading activity, both decisions are exogenous to one another. We interpret these findings as the maturity gap being largely determined by customer liquidity needs, whereas the decision to use swaps relies on compliance with the interest rate risk regulation. Although hedging motives dominate, we find selective hedging behavior in swap use driven by the slope of the yield curve as well as by funding uncertainty. --
    JEL: G21 G32 G33
    Date: 2013
  16. By: Christian Dorion; Pascal François; Gunnar Grass; Alexandre Jeanneret
    Abstract: Given equity’s convex payoff function, shareholders can transfer wealth from bondholders by increasing firm risk. We test the existing hypothesis that convertible debt reduces this classical agency problem of risk-shifting. First, we derive a measure of shareholders’ risk incentives induced by convertible debt using a contingent claims framework. We then document that when risk-shifting incentives are high, the propensity to issue convertible (rather than straight) debt increases and the negative stock market reaction following convertible debt issue announcements is amplified. We further highlight that convertible debt is the only type of security that affects business risk durably downwards. Our conclusions support the agency theoretic rationale for convertible debt financing especially for financially distressed firms.
    Keywords: Convertible bonds, Risk-shifting, Asset substitution, Agency conflict, Financial distress, Asset volatility, Contingent claims
    JEL: G12 G32
    Date: 2014
  17. By: Hott, Christian
    Abstract: This paper examines the impact of implicit guarantees and capital regulations on the behavior of a bank and on the expected losses for its depositors. I show that implicit guarantees increase the incentives of the bank to enhance leverage and/or risk taking and that this leads to higher expected losses for its depositors. To reduce the adverse effects of moral hazard, policy measures have to be taken. However, a simple leverage ratio is likely to increase expected losses further and risk adjusted capital requirements do not necessarily affect highly leveraged banks with very low risk assets. A combination of both requirements can be successful. Positive long-term effects can be achieved by a reduction of moral hazard and informational imperfections. However, it is difficult to achieve these reductions and potentially severe short-term effects have to be taken into account. --
    JEL: G18 G21 G32
    Date: 2013
  18. By: Maier, Ulf; Haufler, Andreas
    Abstract: This paper studies regulatory competition in the banking sector in a model where banks are heterogeneous and taxpayers come up for the losses of failing banks. Capital requirements force the weakest banks to exit the market. This gives rise to a signalling effect of capital standards, as borrowing firms anticipate the higher average quality of banks in a more strictly regulated country. In this model, regulatory competition in capital standards may lead to a `race to the top' for two different reasons. First, if the signalling effect is sufficiently strong, the overall demand for loans from the high-quality banks of the regulating country rises, even though the number of active banks in this country is reduced. Second, if governments are heavily concerned about the tax revenue losses arising from bank failures, strict capital requirements are imposed to improve the pool quality of the domestic banking sector and reduce the risk to taxpayers. --
    JEL: G21 G18 H73
    Date: 2013

This nep-rmg issue is ©2014 by Stan Miles. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.