nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒06‒02
thirteen papers chosen by
Stan Miles
Thompson Rivers University

  1. People Value at Risk: A Key Indicator for Sound Management By Jose Manuel Feria-Dominguez; Enrique Jimenez-Rodriguez; Pilar Camacho-Rubio
  2. Default probabilities and default correlations under stress By Packham, Natalie; Kalkbrener, Michael; Overbeck, Ludger
  3. Achieving an adequate balance between the level of complexity, objectivity and comparability which is required within the capital framework: credit ratings and the Standardized Approach (SA-CCR) for measuring Exposure at Default (EAD) for Counter-Party Credit Risk By Ojo, Marianne
  4. Testing Macroprudential Stress Tests: The Risk of Regulatory Risk Weights By Acharya, Viral V; Engle III, Robert F; Pierret, Diane
  5. Assessing Credit Risk in Money Market Fund Portfolios By Collins, Sean; Gallagher, Emily
  6. Bank capital regulation (BCR) model By Hyejin Cho
  7. VAR and ES/CVAR Dependence on data cleaning and Data Models: Analysis and Resolution By Chris Kenyon; Andrew Green
  8. Bank Insolvency Risk and Z-Score Measures: A Refinement By Frank Strobel
  9. Regime Switches in the Risk-Return Trade-off By Ghysels, Eric; Guérin, Pierre; Marcellino, Massimiliano
  10. Diversification of Geographic Risk in Retail Bank Networks: Evidence from Bank Expansion after the Riegle-Neal Act By Aguirregabiria, Victor; Clark, Robert; Wang, Hui
  11. Liquidity Risk and the Dynamics of Arbitrage Capital By Kondor, Péter; Vayanos, Dimitri
  12. Currency Risk in Currency Unions By Kriwoluzky, Alexander; Müller, Gernot; Wolf, Martin
  13. Heterogeneity in the Value of Life By Aldy, Joseph E.; Smyth, Seamus J.

  1. By: Jose Manuel Feria-Dominguez (Department of Financial Economics and Accounting, Universidad Pablo de Olavide); Enrique Jimenez-Rodriguez (Department of Financial Economics and Accounting, Universidad Pablo de Olavide); Pilar Camacho-Rubio (Department of Financial Economics and Accounting, Universidad Pablo de Olavide)
    Abstract: People are the most important asset for companies, but they are also a source of risk. People risk involves both intentional and unintentional people’s behavior that could provoke losses for firms. The main goal of this paper is twofold: to identify four different risk categories (Internal Fraud, Employment Practices and Workplace Safety, Clients, Products and Business Practices and Execution, Delivery & Process Management) that are “people-related”, and to measure the people risk exposure by applying the concept of People-Value at Risk (People-VaR) as a new key-indicator for sound management in the financial sector. Then, we also calculate the Risk Adjusted Return on Capital (RAROC) to evaluate the bank’s risk-adjusted performance, being both measures useful tools for monitoring the shareholder’s value creation
    Keywords: People Risk, People-Value at Risk, Risk Adjusted return on Capital (RAROC), Banking performance
    Date: 2014–05
  2. By: Packham, Natalie; Kalkbrener, Michael; Overbeck, Ludger
    Abstract: We investigate default probabilities and default correlations of Merton-type credit portfolio models in stress scenarios where a common risk factor is truncated. The analysis is performed in the class of elliptical distributions, a family of light-tailed to heavy-tailed distributions encompassing many distributions commonly found in financial modelling. It turns out that the asymptotic limit of default probabilities and default correlations depend on the max-domain of the elliptical distribution's mixing variable. In case the mixing variable is regularly varying, default probabilities are strictly smaller than 1 and default correlations are in (0; 1). Both can be expressed in terms of the Student t-distribution function. In the rapidly varying case, default probabilities are 1 and default correlations are 0. We compare our results to the tail dependence function and discuss implications for credit portfolio modelling. --
    Keywords: financial risk management,credit portfolio modelling,stress testing,elliptic distribution,max-domain
    Date: 2014
  3. By: Ojo, Marianne
    Abstract: Credit ratings have assumed an increasingly formidable and important role over the years. An increased role and revisions to its foundations, have been triggered, not only in view of the shortcomings of credit ratings based criteria, as revealed through the recent Financial Crisis, but also the need to update Basel II - which has served as the foundation for credit ratings in several jurisdictions. Credit ratings serve various vital purposes, most notably of which include the determination of capital requirements, the identification and classification of assets, and the provision of reliable estimation and assessment of credit risk. The criteria required to be satisfied by credit rating agencies, namely: objectivity, independence, transparency, disclosure, resources and credibility, are closely linked, since the level of comparability and consistency of information provided by such agencies, could also serve as a useful indicator that such information is reliable and credible. In response to the changing financial environment - the evolution and emergence of new and more complex forms of risks and financial products, credit rating agencies have extended their scope beyond the coverage of their traditional products. As well as assessing whether the scope of products presently covered by rating agencies could be deemed adequately relevant to the criteria required to satisfy information being provided as credible, this paper also addresses the reliability of credit scoring methods and models. Are those measures used in estimating the probability of default, namely, financial statements, market prices of a firm’s debt and equity, and appraisals of the firm’s prospects and risk sufficiently indicative as to provide a reliable estimate of the firm's probability of default? The vital role of audits in verifying the credibility of information in financial statements is therefore evident. The reliability and consistency of credit ratings across different jurisdictions, sectors - financial, non financial sectors, and rating agencies, as well as the reliability of the approach for assessing ratings constitute major areas to be addressed. This in part, being attributed to the difficulties with achieving a balance between risk-sensitivity and comparability. The Basel III leverage ratios also being crucial to achieving an acceptable balance with risk-sensitivity - such that the capital framework is not considered unduly risk-sensitive - as was the case with Basel II. The increased importance attributed to credit ratings is also reflected by the Basel Committee’s recent introduction of the Standardized Approach (SA-CCR) for measuring exposure at default (EAD) for counter-party credit risk (CCR). The SA-CCR is intended to replace both current non-internal models approaches, the Current Exposure Method (CEM) and the Standardised Method (SM). The SA-CCR will apply to OTC derivatives, exchange-traded derivatives and long settlement transactions. Risk models have certainly become increasingly complex and relevant - however, is such level of complexity correspondingly and adequately balanced with the level of objectivity and comparability which is required within the capital framework?
    Keywords: credit ratings, OTC derivatives, objectivity, forecasting, assets, liquidity, risk sensitivity, leverage ratios, audits, information asymmetries
    JEL: D8 E3 G2 G28 K2 M4
    Date: 2014–05–25
  4. By: Acharya, Viral V; Engle III, Robert F; Pierret, Diane
    Abstract: Macroprudential stress tests have been employed by regulators in the United States and Europe to assess and address the solvency condition of financial firms in adverse macroeconomic scenarios. We provide a test of these stress tests by comparing their risk assessments and outcomes to those from a simple methodology that relies on publicly available market data and forecasts the capital shortfall of financial firms in severe market-wide downturns. We find that: (i) The losses projected on financial firm balance-sheets compare well between actual stress tests and the market-data based assessments, and both relate well to actual realized losses in case of future stress to the economy; (ii) In striking contrast, the required capitalization of financial firms in stress tests is found to be inadequate ex post compared to that implied by market data; (iii) This discrepancy arises due to the reliance on regulatory risk weights in determining required levels of capital once stress-test losses are taken into account. In particular, the continued reliance on regulatory risk weights in stress tests appears to have left financial sectors under-capitalized, especially during the European sovereign debt crisis, and likely also provided perverse incentives to build up exposures to low risk-weight assets.
    Keywords: macroprudential regulation; risk-weighted assets; stress test; systemic risk
    JEL: G01 G11 G21 G28
    Date: 2014–01
  5. By: Collins, Sean; Gallagher, Emily
    Abstract: This paper measures credit risk in prime money market funds (MMFs), studies how such credit risk evolved in 2011-2012, and tests the efficacy of the Securities and Exchange Commission’s (SEC) January 2010 reforms. To accomplish this, we estimate the credit default swap premium (CDS) needed to insure each fund’s portfolio against credit losses. We also calculate by Monte Carlo the cost of insuring a fund against losses amounting to over 50 basis points. We find that credit risk of prime MMFs rose from June to December 2011 before receding in 2012. Contrary to common perceptions, this did not primarily reflect funds’ credit exposure to eurozone banks. Instead, credit risk in prime MMFs rose because of the deteriorating credit outlook of banks in the Asia-Pacific region. Finally, we find evidence that the SEC’s 2010 liquidity and weighted average life (WAL) requirements reduced the credit risk of prime MMFs.
    Keywords: Money market funds, credit risk, SEC, eurozone, CDS
    JEL: G01 G15 G18 G22 G23 G28
    Date: 2014–05–27
  6. By: Hyejin Cho (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon-Sorbonne)
    Abstract: The motivation of this article is to induce the bank capital management solution for banks and regulation bodies on commercial bank. The goal of the paper is intended to mitigate the risk of banking area and also provide the right incentive for banks to support the real economy.
    Keywords: Demand Deposit; Risks of on-the-balancesheet and off-the-balancesheet; Portfolio composition; minimum equity capital regulation
    Date: 2014–03–12
  7. By: Chris Kenyon; Andrew Green
    Abstract: Historical (Stressed-) Value-at-Risk ((S)VAR), and Expected Shortfall (ES), are widely used risk measures in regulatory capital and Initial Margin, i.e. funding, computations. However, whilst the definitions of VAR and ES are unambiguous, they depend on input distributions that are data-cleaning- and Data-Model-dependent. We quantify the scale of these effects from USD CDS (2004--2014), and from USD interest rates (1989--2014, single-curve setup before 2004, multi-curve setup after 2004), and make two standardisation proposals: for data; and for Data-Models. VAR and ES are required for lifetime portfolio calculations, i.e. collateral calls, which cover a wide range of market states. Hence we need standard, i.e. clean, complete, and common (i.e. identical for all banks), market data also covering this wide range of market states. This data is historically incomplete and not clean hence data standardization is required. Stressed VAR and ES require moving market movements during a past (usually not recent) window to current, and future, market states. All choices (e.g. absolute difference, relative, relative scaled by some function of market states) implicitly define a Data Model for transformation of extreme market moves (recall that 99th percentiles are typical, and the behaviour of the rest is irrelevant). Hence we propose standard Data Models. These are necessary because different banks have different stress windows. Where there is no data, or a requirement for simplicity, we propose standard lookup tables (one per window, etc.). Without this standardization of data and Data Models we demonstrate that VAR and ES are complex derivatives of subjective choices.
    Date: 2014–05
  8. By: Frank Strobel
    Abstract: We re-examine the probabilistic foundation of the link between Z-score measures and banks' probability of insolvency, offering an improved measure and banks' probability of insolvency, offering an improved measure of that probability without imposing further distributional assumptions. While the traditional measure of the probability of insolvency thus provides a less effective upper bound of the probability of insolvency, it can be meaningfully reinterpreted as a measure capturing the odds of insolvency instead. We similarly obtain refined probabilistic interpretations of the commonly used simple and log-transformed Z-score measures; the log of the Z-score is shown to be negatively proportional to the log odds of insolvency, making it an attractive and unproblematic insolvency risk measure more generally.
    Keywords: Insolvency risk; Z-score; probability; odds
    JEL: G21
    Date: 2014–04
  9. By: Ghysels, Eric; Guérin, Pierre; Marcellino, Massimiliano
    Abstract: This paper deals with the estimation of the risk-return trade-off. We use a MIDAS model for the conditional variance and allow for possible switches in the risk-return relation through a Markov-switching specification. We find strong evidence for regime changes in the risk-return relation. This finding is robust to a large range of specifications. In the first regime characterized by low ex-post returns and high volatility, the risk-return relation is reversed, whereas the intuitive positive risk-return trade-off holds in the second regime. The first regime is interpreted as a "flight-to-quality" regime.
    Keywords: conditional variance; Markov-switching; MIDAS; Risk-return trade-off
    JEL: G10 G12
    Date: 2013–10
  10. By: Aguirregabiria, Victor; Clark, Robert; Wang, Hui
    Abstract: The 1994 Riegle Neal (RN) Act removed interstate banking restrictions in the US. The primary motivation was to permit geographic risk diversification (GRD). Using a factor model to measure banks' geographic risk, we show that RN expanded GRD possibilities in small states, but that few banks took advantage. Using our measure of geographic risk and an empirical model of bank choice of branch network, we identify preferences towards GRD separately from the contribution of other factors that may limit the expansion of some banks after RN. Counterfactual experiments based on the estimated structural model show that risk has a significant negative effect on bank value, but this has been counterbalanced by economies of density/scale, reallocation/merging costs, and concerns for local market power.
    Keywords: Branch networks; Commercial banking; Geographic risk diversification; Liquidity risk; Oligopoly competition; Riegle Neal Act
    JEL: G21 L13 L51
    Date: 2014–02
  11. By: Kondor, Péter; Vayanos, Dimitri
    Abstract: We develop a dynamic model of liquidity provision, in which hedgers can trade multiple risky assets with arbitrageurs. We compute the equilibrium in closed form when arbitrageurs' utility over consumption is logarithmic or risk-neutral with a non-negativity constraint. Liquidity is increasing in arbitrageur wealth, while asset volatilities, correlations, and expected returns are hump-shaped. Liquidity is a priced risk factor: assets that suffer the most when liquidity decreases, e.g., those with volatile cashflows or in high supply by hedgers, offer the highest expected returns. When hedging needs are strong, arbitrageurs can choose to provide less liquidity even though liquidity provision is more profitable.
    Keywords: Arbitrage capital; Asset pricing; Liquidity; Liquidity risk; Risk-sharing
    JEL: D53 G01 G11 G12
    Date: 2014–03
  12. By: Kriwoluzky, Alexander; Müller, Gernot; Wolf, Martin
    Abstract: Sovereign yield spreads within currency unions may reflect the risk of outright default. Yet, if exit from the currency union is possible, spreads may also reflect currency risk. In this paper, we develop a New Keynesian model of a small member country of a currency union, allowing both for default within and exit from the union. Initially, the government runs excessive deficits as a result of which it lacks the resources to service the outstanding debt at given prices. We establish two results. First, the initial policy regime is feasible only if market participants expect a regime change to take place at some point, giving rise to default and currency risk. Second, the macroeconomic implications of both sources of risk differ fundamentally. We also analyze the 2009--2012 Greek crisis, using the model to identify the beliefs of market participants regarding regime change. We find that currency risk accounts for about a quarter of Greek yield spreads.
    Keywords: currency risk; Currency union; default; euro; exit; fiscal deficits; Greek crisis; irreversibility; spreads
    JEL: E62 F41
    Date: 2013–09
  13. By: Aldy, Joseph E.; Smyth, Seamus J.
    Abstract: We develop a numerical life-cycle model -- with choice over consumption and leisure, stochastic mortality and labor income processes, and calibrated to U.S. data -- to characterize willingness to pay (WTP) for mortality risk reduction. Our theoretical framework can explain many empirical findings in this literature, including an inverted-U life-cycle WTP and an order of magnitude difference in prime-aged adults WTP. By endogenizing leisure and employing multiple income measures, we reconcile the literature's large variation in estimated income elasticities. By accounting for gender- and race-specic stochastic mortality and income processes, we explain the literature's black-white and female-male differences.
    Keywords: value of statistical life, mortality risk reduction, income elasticity
    JEL: J17 D91 Q51
    Date: 2014–05–21

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