
on Risk Management 
Issue of 2014‒03‒30
fourteen papers chosen by 
By:  Detzer, Daniel 
Abstract:  This paper examines capital adequacy regulation in Germany. After a short overview about financial regulation in Germany in general, the paper focuses on the most important development in the area of capital adequacy regulation from the 1930s up to the financial crisis. Two main trends are identified: a gradual softening of the eligibility criteria for regulatory equity and the increasing reliance on banks' internal risk models for the determination of risk weights. The first trend has been reversed with the regulatory reforms following the financial crisis. Internal risk models will still play a central role. The rest of the paper focuses on the problems with the use of internal risk models for regulatory purposes. The discussion includes the moral hazard problem, the technical problems with the models, the difference between economically and socially optimal capital requirements, the procyclicality of the models and the problem occurring due to the existence of fundamental uncertainty. The regulatory reforms due to Basel 2.5 and Basel III and their potential to alleviate the identified problems are then examined. It is concluded that those cannot solve the most relevant problems and that currently the use of models for financial regulation is problematic. Finally, some suggestions of how the problems could be addressed are given.  
Keywords:  Banking Regulation,Financial Regulation,Capital Requirements,Capital Adequacy,Bank Capital,Basel Accord,Risk Management,Risk Models,Germany 
JEL:  G18 G28 N24 N44 
Date:  2014 
URL:  http://d.repec.org/n?u=RePEc:zbw:eabhps:1404&r=rmg 
By:  AMARANTE, Massimiliano 
Abstract:  We provide a representation theorem for risk measures satisfying (i) monotonicity; (ii) positive homogeneity; and (iii) translation invariance. As a simple corollary to our theorem, we obtain the usual representation of coherent risk measures (i.e., risk measures that are, in addition, subadditive; see Artzner et al. [2]). 
Keywords:  Risk measures; capacity; Choquet integral 
JEL:  G11 C65 
Date:  2013 
URL:  http://d.repec.org/n?u=RePEc:mtl:montde:201308&r=rmg 
By:  Jaehyung Choi; Aaron Kim; Ivan Mitov 
Abstract:  We implement momentum strategies based on rewardrisk measures as ranking criteria using classical tempered stable distribution. The performance and risk characteristics of the portfolios are obtained in various asset classes and markets. The rewardrisk momentum strategies outperform the traditional momentum strategy with lower volatility level regardless of asset class and market. Additionally, the alternative portfolios are not only less riskier in risk measures such as VaR, CVaR, and maximum drawdown but also characterized by thinner downside tails. Similar patterns in performance and risk profiles are also found at the level of each ranking basket in the alternative portfolios. Larger factorneutral returns achieved by the rewardrisk momentum strategies are statistically significant and the large portions of the performance are not explained by the FamaFrench threefactor model. 
Date:  2014–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1403.6093&r=rmg 
By:  Selim Mankaï; Aymen Belgacem 
Abstract:  Theory and empirical evidence recognize interactions between capital and risk. This paper analyzes the effect of reinsurance, as a new endogenous decision variable, on this policy mix using simultaneous equations model. Empirical results obtained from a sample of U.S. propertyliability insurance firms reveal significant interactions between capital, risk, and reinsurance. The relationship between risk and capital is positive, highlighting the effectiveness of regulatory mechanisms. Reinsurance is negatively associated with capital, for which it appears to act as a substitute. These results are strongly sensitive to the level of capital held in excess of the regulatory minimum requirements. Weakly capitalized firms adjust their reinsurance and risk levels more extensively and try to rebuild an appropriate capital buffer. Unlike other decision variables, the capital ratio converges toward a target level. 
Keywords:  Risktaking, Capital Regulation, Reinsurance, Simultaneous Equations, Instrumental Variables. 
JEL:  G22 G28 G32 
Date:  2014–02–25 
URL:  http://d.repec.org/n?u=RePEc:ipg:wpaper:2014154&r=rmg 
By:  B. Podobnik; D. Horvatic; M. Bertella; L. Feng; X. Huang; B. Li 
Abstract:  Complex nonlinear interactions between banks and assets we model by two timedependent Erd\H{o}s Renyi network models where each node, representing bank, can invest either to a single asset (model I) or multiple assets (model II). We use dynamical network approach to evaluate the collective financial failuresystemic riskquantified by the fraction of active nodes. The systemic risk can be calculated over any future time period, divided on subperiods, where within each subperiod banks may contiguously fail due to links to either (i) assets or (ii) other banks, controlled by two parameters, probability of internal failure $p$ and threshold $T_h$ (``solvency'' parameter). The systemic risk nonlinearly increases with $p$ and decreases with average network degree faster when all assets are equally distributed across banks than if assets are randomly distributed. The more inactive banks each bank can endure (smaller $T_h$), the smaller the systemic riskfor some $T_h$ values in {\bf I} we report a discontinuity in systemic risk. When contiguous spreading becomes stochastic (ii) controlled by probability $p_2$a condition for the bank to be solvent (active) is stochasticwith increasing $p_2$, the systemic risk decreases with both $p$ and $T_h$. We analyse asset allocation for the U.S. banks. 
Date:  2014–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1403.5623&r=rmg 
By:  Nauta, BertJan 
Abstract:  Most of the assets on the balance sheet of typical banks are illiquid. This exposes banks to liquidity risk, which is one of the key risks for banks. Since the value of assets is determined by their risks, liquidity risk should be included in valuation. This paper develops a valuation framework for liquidity risk. An important element of the framework is the definition and derivation of an optimal admissible liquidation strategy that describes the assets a bank will liquidate in case of a liquidity stress event (LSE). The main result is that the discount rate includes a liquidity spread that is composed of three elements: 1. the probability of an LSE, 2. the severity of an LSE, and 3. the liquidation value of the asset. The framework is illustrated by application to a stylized bank balance sheet. 
Keywords:  valuation; liquidity spread; discounting; liquidity risk; 
JEL:  G12 G13 G21 
Date:  2013–04–01 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:54781&r=rmg 
By:  Gete, Pedro; Tiernan, Natalie 
Abstract:  We propose a quantitative model of lending standards with two reasons for inefficient credit: lenders' moral hazard from deposit insurance or government guarantees, and imperfect information about the persistence of asset price growth, which generates incorrect but rational beliefs in the lenders. We calibrate the model to match recent credit boombust episodes. Then we study which patterns of real estate price growth and banks' beliefs could serve as early warning indicators of a crisis. Finally, we propose a ValueatRisk (VaR) rule to implement the capital requirements. The VaR framework ensures that the probability of banks not having enough equity to cover their losses is maintained at a certain level. Capital requirements should be statecontingent and lean against lenders' beliefs by tightening after periods of asset price growth. However, the relationship between asset price growth and financial risk is not monotone and this should be integrated in the setting of the capital requirements and early warning indicators. 
Keywords:  Lending Standards, Capital Requirements, Leverage Rules, VaR, Basel III 
JEL:  E44 G2 G21 G28 
Date:  2014–03 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:54486&r=rmg 
By:  Castiglionesi, Fabio; Feriozzi, Fabio; Lóránth, Gyöngyi; Loriana Pelizzon 
Abstract:  Banks can deal with their liquidity risk by holding liquid assets (selfinsurance), by participating in interbank markets (coinsurance), or by using flexible financing instruments, such as bank capital (risksharing). We use a simple model to show that undiversi fiable liquidity risk, i.e. the liquidity risk that banks are unable to coinsure on interbank markets, represents an important risk factor affecting their capital structures. Banks facing higher undiversi fiable liquidity risk hold more capital. We posit that empirically banks that are more exposed to undiversifi able liquidity risk are less active on interbank markets. Therefore, we test for the existence of a negative relationship between bank capital and interbank market activity and find support in a large sample of U.S. commercial banks.  
Keywords:  Bank Capital,Interbank Markets,Liquidity Coinsurance 
JEL:  G21 
Date:  2014 
URL:  http://d.repec.org/n?u=RePEc:zbw:safewp:45&r=rmg 
By:  Heejoon Han; Oliver Linton (Institute for Fiscal Studies and Cambridge University); Tatsushi Oka; YoonJae Whang (Institute for Fiscal Studies and Seoul National University) 
Abstract:  This paper proposes the crossquantilogram to measure the quantile dependence between two time series. We apply it to test the hypothesis that one time series has no directional predictability to another time series. We establish the asymptotic distribution of the cross quantilogram and the corresponding test statistic. The limiting distributions depend on nuisance parameters. To construct consistent confiÂ…dence intervals we employ the stationary bootstrap procedure; we show the consistency of this bootstrap. Also, we consider the selfnormalized approach, which is shown to be asymptotically pivotal under the null hypothesis of no predictability. We provide simulation studies and two empirical applications. First, we use the crossquantilogram to detect predictability from stock variance to excess stock return. Compared to existing tools used in the literature of stock return predictability, our method provides a more complete relationship between a predictor and stock return. Second, we investigate the systemic risk of individual fiÂ…nancial institutions, such as JP Morgan Chase, Goldman Sachs and AIG. This article has supplementary materials online. 
Date:  2014–02 
URL:  http://d.repec.org/n?u=RePEc:ifs:cemmap:06/14&r=rmg 
By:  Karol Przanowski 
Abstract:  The paper is aware of the importance of certain figures that are essential to an understanding of Credit Scoring models in credit acceptance process optimization, namely if the power of discrimination measured by Gini value is increased by 5% then the profit of the process can be increased monthly by about 1 500 kPLN (300 kGBP, 500 kUSD, 350 kEUR). Simple business models of credit loans are also presented: acquisition  installment loan (low price) and crosssell  cash loans (high price). Scoring models are used to optimize process, to become profitable. Various acceptance strategies with different cutoffs are presented, some are profitable and some are not. Moreover, in a time of prosperity some are preferable whilst the inverse is true during a period of high risk or crisis. To optimize the process four models are employed: three risk models, to predict the probability of default and one typical propensity model to predict the probability of response. It is a simple but very important example of the Customer Lifetime Value (CLTV or CLV) model business, where risk and response models are working together to become a profitable process. 
Date:  2014–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1403.6531&r=rmg 
By:  Mehta, Salil 
Abstract:  This note explores the mathematical theory to solve modern gambler’s ruin problems. We establish a ruin framework and solve for the probability of bankruptcy. We also show how this relates to the expected time to bankruptcy and review the risk neutral probabilities associated an adjustment to asymmetrical views. 
Keywords:  mathematical theory, gambler’s ruin, statistics, risk, probability, bankruptcy, finance, asymmetrical views, investments 
JEL:  C1 G11 
Date:  2013–11–18 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:54731&r=rmg 
By:  Randle, Tony; Rudolph, Heinz P. 
Abstract:  Defined contribution pension systems have faced criticism in the wake of the financial and economic crisis for not delivering adequate and sustainable pension incomes at retirement. Much of the problem has centered around the misalignment of pension fund management companies and the interests of pension fund members, with the focus on shortterm volatility rather than delivering adequate pension income over the long term. Although pension fund supervisors in emerging economies have attempted to correct for these market failures, they have not focused sufficiently on the ultimate longterm pension income objective. The paper suggests that in order to have a meaningful impact on future pensions, the supervision of defined contribution pension systems needs to take a more proactive role in minimizing pension risk. This objective would require ensuring that investment risks are aligned with the probability of achieving a target pension at retirement age. The paper also suggests that a proper institutional design of the pension fund industry and intensive use of market surveillance are efficient tools for dealing with most of the operational risks of funded pension fund schemes in emerging economies. 
Keywords:  Debt Markets,Financial Literacy,Emerging Markets,Mutual Funds,Pensions&Retirement Systems 
Date:  2014–03–01 
URL:  http://d.repec.org/n?u=RePEc:wbk:wbrwps:6813&r=rmg 
By:  Karl Mina (Centre for Industrial and Applied Mathematics, School of Mathematics and Statistics, University of South Australia); Gerald Cheang (Centre for Industrial and Applied Mathematics, School of Mathematics and Statistics, University of South Australia); Carl Chiarella (Finance Discipline Group, UTS Business School, University of Technology, Sydney) 
Abstract:  We consider the problem of hedging a Europeantype option in a market where asset prices have jumpdiffusion dynamics. It is known that markets with jumps are incomplete in the context of Harrison and Pliska (1981) and that there are several riskneutral measures one can use to price and hedge options (Cont and Tankov, 2004; Miyahara, 2012). As in Jensen (1999) and Leon et al. (2002), we approximate such a market by discretizing the jumps in an averaged sense, and complete it by including traded options in the model and hedge portfolio as utilized in Cont et al. (2007) and He et al. (2006). Under suitable conditions, we get a unique riskneutral measure, which is used to determine the option price partial differential equation, along with the asset positions that will replicate the option payoff. This procedure is then implemented on a particular set of stock and option prices, and its performance is compared with the minimal variance and delta hedging strategies. 
Date:  2013–12–01 
URL:  http://d.repec.org/n?u=RePEc:uts:rpaper:340&r=rmg 
By:  Daniel Harenberg; Alexander Ludwig 
Abstract:  We ask whether a PAYGfinanced social security system is welfare improving in an economy with idiosyncratic and aggregate risk. We argue that interactions between the two risks are important for this question. One is a direct interaction in the form of a countercyclical variance of idiosyncratic income risk. The other indirectly emerges over a household's lifecycle because retirement savings contain the history of idiosyncratic and aggregate shocks. We show that this leads to risk interactions, even when risks are statistically independent. In our quantitative analysis, we find that introducing social security with a contribution rate of two percent leads to welfare gains of $2.2 \%$ of lifetime consumption in expectation, despite substantial crowding out of capital. This welfare gain stands in contrast to the welfare losses documented in the previous literature, which studies one risk in isolation. We show that jointly modeling both risks is crucial: 60% of the welfare benefits from insurance result from the interactions of risks. 
Keywords:  social security, idiosyncratic risk, aggregate risk, welfare 
URL:  http://d.repec.org/n?u=RePEc:stz:wpaper:ethrc14002&r=rmg 