nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒04‒18
thirteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Margin Requirements and Portfolio Optimization: A Geometric Approach By Sheng Guo
  2. Fat-tails in VAR Models By Ching-Wai (Jeremy) Chiu; Haroon Mumtaz; Gabor Pinter
  3. Systemic risk in an interconnected banking system with endogenous asset markets By Bluhm, Marcel; Krahnen, Jan Pieter
  4. Regularizing Portfolio Risk Analysis: A Bayesian Approach By Sourish Das; Dipak K. Dey
  5. Financial Market Regulation in Germany - Capital Requirements of Financial Institutions By Daniel Detzer
  6. Systemic importance of financial institutions: regulations, research, open issues, proposals By Michele Bonollo; Irene Crimaldi; Andrea Flori; Fabio Pammolli; Massimo Riccaboni
  7. Forecasting Bankruptcy with Incomplete Information By Xu, Xin
  8. Systemic Risk in the Financial Industry: “Mimetism” for the Best and for the Worst By Thierry Warin; Robert E. Prasch
  9. Does “Skin in the Game” Reduce Risk Taking? Leverage, Liability and the Long-Run Consequences of New Deal Financial Reforms By Mitchener, Kris James; Richardson, Gary
  10. Pay Attention or Pay Extra: Evidence on the Compensation of Investors for the Implicit Credit Risk of Structured Products By Arnold, Marc; Schuette, Dustin; Wagner, Alexander
  11. Wholesale Funding, Coordination, and Credit Risk By Zhang, Lei; Zhang, Lin; Zheng, Yong
  12. Ending over-lending: Assessing systemic risk with debt to cash flow By Ramsay, Bruce A.; Sarlin, Peter
  13. Valuation of Small and Multiple Health Risks: A Critical Analysis of SP Data Applied to Food and Water Safety By Henrik Andersson; Arne Risa Hole; Mikael Svensson

  1. By: Sheng Guo (Department of Economics, Florida International University)
    Abstract: Using geometric illustrations, we investigate what implications of portfolio optimization in equilibrium can be generated by the simple mean-variance framework, under margin borrowing restrictions. First, we investigate the case of uniform marginability on all risky assets. It is shown that changing from unlimited borrowing to margin borrowing shifts the market portfolio to a riskier combination, accompanied by a higher risk premium and a lower price of risk. With the linear risk-return preference, more stringent margin requirements lead to a riskier market portfolio, contrary to the conventional belief. Second, we investigate the effects of differential marginability on portfolio optimization by allowing only one of the risky assets to be pledged as collateral. It is shown that the resulting optimal portfolio is not always tilted towards holding more of the marginable asset, when the margin requirement is loosened.
    Keywords: portfolio optimization; margin; collateral; borrowing constraint; mean-variance; efficient frontier; asset allocation
    JEL: G11
    Date: 2014–04
  2. By: Ching-Wai (Jeremy) Chiu (Bank of England); Haroon Mumtaz (Queen Mary University of London); Gabor Pinter (Bank of England)
    Abstract: We confirm that standard time-series models for US output growth, inflation, interest rates and stock market returns feature non-Gaussian error structure. We build a 4-variable VAR model where the orthogonolised shocks have a Student t-distribution with a time-varying variance. We find that in terms of in-sample fit, the VAR model that features both stochastic volatility and Student-t disturbances outperforms restricted alternatives that feature either attributes. The VAR model with Student-t disturbances results in density forecasts for industrial production and stock returns that are superior to alternatives that assume Gaussianity. This difference appears to be especially stark over the recent financial crisis.
    Keywords: Bayesian VAR, Fat tails, Stochastic volatility
    JEL: C32 C53
    Date: 2014–03
  3. By: Bluhm, Marcel; Krahnen, Jan Pieter
    Abstract: We analyze the emergence of systemic risk in a network model of interconnected bank balance sheets. The model incorporates multiple sources of systemic risk, including size of financial institutions, direct exposure from interbank lendings, and asset fire sales. We suggest a new macroprudential risk management approach building on a system wide value at risk (SVaR). Under the SVaR metric, the contribution of individual banks to systemic risk is well defined and can be approximated by a Shapley value-type measure. We show that, in a SVaR regime, a fair systemic risk charge which is proportional to a bank's individual contribution to systemic risk diverges from the optimal macroprudential capitalization of the banks from a planner's perspective. The results have implications for the design of macroprudential capital surcharges. --
    Keywords: systemic risk,systemic risk charge,macroprudential supervision,Shapley value,financial network
    JEL: C15 G01 G21 G28
    Date: 2014
  4. By: Sourish Das; Dipak K. Dey
    Abstract: It is important for portfolio manager to estimate and analyze the recent portfolio volatility to keep portfolio's risk within limit. Though number of financial instruments in the portfolio are very large, some times more than thousands, however daily returns considered for analysis is only for a month or even less. In this case rank of portfolio covariance matrix is less than full, hence solution is not unique. It is typically known as "large $p$ - small $n$" or "ill-posed" problem. In this paper we discuss a Bayesian approach to regularize the problem. One of the additional advantages of this approach is to analyze the source of risk by estimating the probability of positive `conditional contribution to total risk' (CCTR). Each source's CCTR sum upto total volatility risk. Existing method only estimates CCTR of a source, but it does not estimate the probability of CCTR to be significantly greater (or less) than zero. This paper presents Bayesian methodology to do so. We use parallalizable and easy to use Monte Carlo (MC) approach to achieve our objective.
    Date: 2014–04
  5. By: Daniel Detzer (Berlin School of Economics and Law, and Institute for International Political Economy Berlin (IPE))
    Abstract: This paper examines capital adequacy regulation in Germany. After a general overview of financial regulation in Germany, 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 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: 2014–02–15
  6. By: Michele Bonollo (Credito trevigiano); Irene Crimaldi (IMT Lucca Institute for Advanced Studies); Andrea Flori (IMT Lucca Institute for Advanced Studies); Fabio Pammolli (IMT Lucca Institute for Advanced Studies); Massimo Riccaboni (IMT Lucca Institute for Advanced Studies)
    Abstract: In the field of risk management, scholars began to bring together the quantitative methodologies with the banking management issues about 30 years ago, with a special focus on market, credit and operational risks. After the systemic effects of banks defaults during the recent financial crisis, and despite a huge amount of literature in the last years concerning the systemic risk, no standard methodologies have been set up to now. Even the new Basel 3 regulation has adopted a heuristic indicator-based approach, quite far from an effective quantitative tool. In this paper, we refer to the different pieces of the puzzle: definition of systemic risk, a set of coherent and useful measures, the computability of these measures, the data set structure. In this challenging field, we aim to build a comprehensive picture of the state of the art, to illustrate the open issues, and to outline some paths for a more successful future research. This work appropriately integrates other useful surveys and it is directed to both academic researchers and practitioners.
    Keywords: Systemic Risk, Counterparty risk, Financial Networks, Basel regulations, European Market Infrastructure Regulation
    JEL: G01 G18 G21
    Date: 2014–03
  7. By: Xu, Xin
    Abstract: We propose new specifications that explicitly account for information noise in the input data of bankruptcy hazard models. The specifications are motivated by a theory of modeling credit risk with incomplete information (Duffie and Lando [2001]). Based on over 2 million firm-months of data during 1979-2012, we demonstrate that our proposed specifications significantly improve both in-sample model fit and out-of-sample forecasting accuracy. The improvements in forecasting accuracy are persistent throughout the 10-year holdout periods. The improvements are also robust to empirical setup, and are more substantial in cases where information quality is a more serious problem. Our findings provide strong empirical support for using our proposed hazard specifications in credit risk research and industry applications. They also reconcile conflicting empirical results in the literature.
    Keywords: Credit Risk Modeling, Incomplete Information, Hazard Models, Bankruptcy Forecast, Probability of Default (PD), Forecasting Accuracy, Intensity-based Models, Reduced-form Models, Duration Analysis, Survival Analysis
    JEL: C41 G17 G33
    Date: 2013–05–28
  8. By: Thierry Warin; Robert E. Prasch
    Abstract: In the wake of the worst financial crisis since 1929, economists are revisiting the received understanding of how financial markets and institutions actually operate. This paper aims to contribute to this reexamination. It builds upon the traditional and widely-accepted mean-variance approach to the processing of information under conditions of risk while reconsidering an inadequately contemplated premise: the actual organization of the financial market. Now, a lot has been said about perverse incentives and contracting arrangements, firms with oligopolistic power, the pricing and market advantages of being too big to fail, and the associated inefficiencies of the regulatory and supervision systems. While we believe that much of that work is valid, we also believe that too little has been done to meld modern portfolio theory (MPT) with insights that can be drawn from recent developments in Industrial Organization. In the model presented here, the MPT finds its place through the "coordination" mechanism, which is the transmission of financial information among agents. The IO perspective finds its place in our model through a variable capturing the fragility of the system: the probability that the quality of information can itself be altered by the system’s "complexity," which in its extreme from can be described as "opacity."
    Keywords: systemic risk, specific risk, systematic risk, financial industry, modern portfolio theory, complexity, opacity, Minsky moment, complex systems,
    Date: 2013–08–01
  9. By: Mitchener, Kris James (University of Warwick); Richardson, Gary (University of California, Irvine)
    Abstract: We examine how the Banking Acts of the 1933 and 1935 and related New Deal legislation influenced risk taking in the financial sector of the U.S. economy. Our analysis focuses on contingent liability of bank owners for losses incurred by their firms and how the elimination of this liability influenced leverage and lending by commercial banks. Using a new panel data set that compares balance sheets of state and national banks, we find contingent liability reduced risk taking, particularly when coupled with rules requiring banks to join the Federal Deposit Insurance Corporation. Leverage ratios are higher in states with limited liability for bank owners. Banks in states with contingent liability converted each dollar of capital into fewer loans, and thus could sustain larger loan losses (as a fraction of their portfolio) than banks in limited liability states. The New Deal replaced a regime of contingent liability with stricter balance sheet regulation and increased capital requirements, shifting the onus of risk management from banks to state and federal regulators. By separating investment banks from commercial banks, the Glass-Steagall Act left investment banks to manage their own leverage, a feature of financial regulation that, in part, depended on their partnership structure.
    Date: 2013
  10. By: Arnold, Marc; Schuette, Dustin; Wagner, Alexander
    Abstract: This paper analyzes the pricing of issuer credit risk in retail structured products. After the default of Lehman Brothers, investors are compensated for the counterparty risk they bear if the products are not constructed to provide an implicit “credit enhancement", i.e., if they do not feature a sufficiently high correlation of the promised payout and the issuer's financial health. Before the financial crisis, and during the crisis up to the default of Lehman Brothers, investors are not compensated for credit risk. As the default of Lehman Brothers has arguably sharpened investors' attention for counterparty risk, these results suggest that whether issuers compensate investors for a certain risk does not only depend on the level but on investors' awareness for the corresponding risk. Our findings have regulatory and policy implications.
    Keywords: Structured products, credit risk, risk awareness
    JEL: D8 G34 M52
  11. By: Zhang, Lei (University of Warwick); Zhang, Lin (Southwestern University of Finance and Economics); Zheng, Yong (Southwestern University of Finance and Economics)
    Abstract: We use the global games approach to study key factors a?ecting the credit risk associated with roll-over of bank debt. When creditors are heterogenous, these include the extent of short-term borrowing and capital market liquidity for repo ?nancing. Speci?cally, in a model with a large institutional creditor and a continuum of small creditors independently making their roll-over decisions based on private information, we ?nd that increasing the proportion of short-term debt and/or decreasing market liquidity reduces the willingness of creditors to roll over. This raises credit risk in equilibrium. The presence of a large creditor does not always reduce credit risk, however, unless it is better informed.
    Keywords: Credit Risk; Coordination; Debt Crisis; Private information; Global games
    Date: 2013
  12. By: Ramsay, Bruce A. (Cascadia Monetary Research, Alberta, Canada; and RiskLab Finland at IAMSR, Åbo Akademi University and Arcada University of Applied Sciences, Finland); Sarlin, Peter (Center of Excellence SAFE at Goethe University Frankfurt, Germany, and RiskLab Finland at IAMSR, Åbo Akademi University and Arcada University of Applied Sciences, Finland)
    Abstract: This paper operationalizes early theoretical contributions of Hyman Minsky and applies these in the context of economic sectors and nations. Following the view of boom-bust asset cycles, depicted by the endogenous build-up of risks and their abrupt unraveling, Minsky highlighted the relationship between debt obligations and cash flows. While leverage is oftentimes linked to the vulnerability of a nation, and hence systemic risk, one less explored measure of leverage is the debt-to-cash flow ratio (Debt/CF). Cash flows certainly have a well-known, academically verified connection to the ability of corporations to service and repay corporate debt. This paper investigates whether the relationship between the flow of a nation's savings to its stock of total debt provides a means for understanding systemic risks. For a panel of 33 nations, we explore historic Debt/CF trends, as well as apply the same procedure to individual economic sectors. This assessment of systemic risk is arranged for presentation within a four-zone framework. In terms of an early-warning indicator, we show that the Debt/CF ratio effectively stratifies systemic risks, and offers a useful platform toward macro-financial sustainability.
    Keywords: debt-to-cash flow; debt-to-gross saving; systemic risk; four-zone framework
    JEL: E21 F34 G01 H63
    Date: 2014–04–03
  13. By: Henrik Andersson (Toulouse School of Economics (LERNA)); Arne Risa Hole (University of Sheffield); Mikael Svensson (Karlstad University)
    Abstract: This study elicits individual preferences for reducing morbidity and mortality risk in the context of an infectious disease (campylobacter) using choice experiments. Respondents are in the survey asked to choose between different policies that, in addition to the two health risks, also vary with respect to source of disease being targeted (food or water), when the policy takes place (in time), and the monetary cost. Our results in our baseline model are in line with expectations; respondents prefer the benefits of the program sooner than later, programs that reduce both the mortality and morbidity risk, and less costly programs. Moreover, our results suggest that respondents prefer water- compared with food-safety programs. However, a main objective of this study is to examine scope sensitivity of mortality risk reductions using a novel approach. Our results from a split-sample design suggest that the value of the mortality risk reduction, defined as the value of a statistical life, is SEK 3 177 (USD 483 million) and SEK 50 million (USD 8 million), respectively, in our two sub-samples. This result cast doubt on the standard scope sensitivity tests in choice experiments, and the results also cast doubt on the validity and reliability of VSL estimates based on stated preference (and revealed preference) studies in general. This is important due to the large empirical literature on non-market evaluation and the elicited values' central role in policy making, such as benefit-cost analysis.
    Keywords: choice experiments; morbidity risk; mortality risk; scope sensitivity; willingness to pay
    JEL: D61 H41 I18 Q51
    Date: 2014–04

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