nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒11‒01
fourteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Sequential Monte Carlo Samplers for capital allocation under copula-dependent risk models By Rodrigo S. Targino; Gareth W. Peters; Pavel V. Shevchenko
  2. Risk-sharing or risk-taking? An incentive theory of counterparty risk, clearing and margins By Biais, Bruno; Heider, Florian; Hoerova, Marie
  3. Banking competition and stability: The role of leverage By Xavier Freixas; Kebin Ma
  4. Risk diversification: a study of persistence with a filtered correlation-network approach By Nicol\'o Musmeci; Tomaso Aste; Tiziana Di Matteo
  5. Does the capital structure affect banks’ profitability? Pre- and post financial crisis evidence from significant banks in France By 0. De Bandt; B. Camara; P. Pessarossi; M. Rose
  6. Managerial Compensation, Regulation and Risk in Banks: Theory and Evidence from the Financial Crisis By Vittoria Cerasi; Tommaso Oliviero
  7. European Market Portfolio Diversifcation Strategies across the GFC By David E. Allen; Michael McAleer; Robert J. Powell; Abhay K. Singh
  8. Managing Default Risk By Anna Zabai
  9. Monte Carlo Approximate Tensor Moment Simulations By Juan C. Arismendi; Herbert Kimura
  10. How does risk management influence production decisions? evidence from a field experiment By Cole, Shawn; Gine, Xavier; Vickery, James
  11. Interbank Lending and Distress: Observables, Unobservables, and Network Structure By Craig, Ben R.; Koetter, Michael; Kruger, Ulrich
  12. What is the information content of the SRISK measure as a supervisory tool? By S. Tavolaro; F. Visnovsky
  13. Does diversity of bank board members affect performance and risk? Evidence from an emerging market By Bowo Setiyono; Amine Tarazi
  14. Optimal Monitoring and Mitigation of Systemic Risk in Financial Networks By Zhang Li; Xiaojun Lin; Borja Peleato-Inarrea; Ilya Pollak

  1. By: Rodrigo S. Targino; Gareth W. Peters; Pavel V. Shevchenko
    Abstract: In this paper we assume a multivariate risk model has been developed for a portfolio and its capital derived as a homogeneous risk measure. The Euler (or gradient) principle, then, states that the capital to be allocated to each component of the portfolio has to be calculated as an expectation conditional to a rare event, which can be challenging to evaluate in practice. We exploit the copula-dependence within the portfolio risks to design a Sequential Monte Carlo Samplers based estimate to the marginal conditional expectations involved in the problem, showing its efficiency through a series of computational examples.
    Date: 2014–10
  2. By: Biais, Bruno; Heider, Florian; Hoerova, Marie
    Abstract: Derivatives activity, motivated by risk-sharing, can breed risk taking. Bad news about the risk of the asset underlying the derivative increases the expected liability of a protection seller and undermines her risk prevention incentives. This limits risk-sharing, and may create endogenous counterparty risk and contagion from news about the hedged risk to the balance sheet of protection sellers. Margin calls after bad news can improve protection sellers incentives and enhance the ability to share risk. Central clearing can provide insurance against counterparty risk but must be designed to preserve risk-prevention incentives.
    Keywords: Hedging; Insurance; Derivatives; Moral hazard; Risk management;Counterparty risk; Contagion; Central clearing; Margin requirements
    JEL: D82 G21 G22
    Date: 2014–06
  3. By: Xavier Freixas; Kebin Ma
    Abstract: This paper reexamines the classical issue of the possible trade-offs between banking competition and financial stability by highlighting different types of risk and the role of leverage. By means of a simple model we show that competition can affect portfolio risk, insolvency risk, liquidity risk, and systemic risk differently. The effect depends crucially on banks' liability structure, on whether banks are financed by insured retail deposits or by uninsured wholesale debts, and on whether the indebtness is exogenous or endogenous. In particular we suggest that, while in a classical originate-to-hold banking industry competition might increase financial stability, the opposite can be true for an originate-to-distribute banking industry of a larger fraction of market short-term funding. This leads us to revisit the existing empirical literature using a more precise classification of risk. Our theoretical model therefore helps to clarify a number of apparently contradictory empirical results and proposes new ways to analyze the impact of banking competition on financial stability.
    Keywords: Banking Competition, Financial Stability, Leverage
    JEL: G21 G28
    Date: 2014–08
  4. By: Nicol\'o Musmeci; Tomaso Aste; Tiziana Di Matteo
    Abstract: The evolution with time of the correlation structure of equity returns is studied by means of a filtered network approach investigating persistences and recurrences and their implications for risk diversification strategies. We build dynamically Planar Maximally Filtered Graphs from the correlation structure over a rolling window and we study the persistence of the associated Directed Bubble Hierarchical Tree (DBHT) clustering structure. We observe that the DBHT clustering structure is quite stable during the early 2000' becoming gradually less persistent before the unfolding of the 2007-2008 crisis. The correlation structure eventually recovers persistence in the aftermath of the crisis settling up a new phase, distinct from the pre-cysts structure, where the market structure is less related to industrial sector activity. Notably, we observe that - presently - the correlation structure is loosing again persistence indicating the building-up of another, different, phase. Such dynamical changes in persistence and their occurrence at the unfolding of financial crises rises concerns about the effectiveness of correlation-based portfolio management tools for risk diversification.
    Date: 2014–10
  5. By: 0. De Bandt; B. Camara; P. Pessarossi; M. Rose
    Abstract: This paper studies the effect of banks’ capitalization on banks’ Return on Equity (ROE). A debate has emerged on the costs for banks of the increase in capital requirements under Basel III. We bring empirical evidence on this issue by analyzing the effect of different capitalization measures on banks’ ROE on a sample of large French banks over the period 1993-2012, controlling for risk-taking as well as a range of variables including the business model. We find that an increase in capital leads to a significant increase in ROE, albeit the economic effect is modest. Furthermore, the method chosen by a bank to increase capitalization (i.e. raising equity) does not alter the result. Over the period, we find some evidence of a negative relationship between the share of credit activities and ROE, which is driven by the 2002-2007 sub-period, characterized by a significant increase in other business line activities. Looking at revenue and cost components, the positive effect of capital on the ROE appears to be driven by an increase in efficiency.
    Keywords: ROE, solvency ratios, capital, banking regulation, Basel III.
    JEL: G21 G28
    Date: 2014
  6. By: Vittoria Cerasi (Università di Milano Bicocca); Tommaso Oliviero (CSEF, Università di Napoli Federico II)
    Abstract: This paper analyzes the relation between CEOs monetary incentives, financial regulation and risk in banks. We present a model where banks lend to opaque entrepreneurial projects to be monitored by managers; managers are remunerated according to a pay-for-performance scheme and their effort is unobservable to depositors and shareholders. Within a prudential regulatory framework that defines a capital requirement and a deposit insurance, we study the effect of increasing the variable component of managerial compensation on risk taking. We then test empirically how monetary incentives provided to CEOs in 2006 affected banks' stock price and volatility during the 2007-2008 financial crisis on a sample of large banks around the World. The cross-country dimension of our sample allows us to study the interaction between CEO incentives and financial regulation. The empirical analysis suggests that the sensitivity of CEOs equity portfolios to stock prices and volatility has been indeed related to worse performance in countries with explicit deposit insurance and weaker monitoring by shareholders. This evidence is coherent with the main prediction of the model, that is, the variable part of the managerial compensation, combined with weak insiders' monitoring, exacerbates the risk-shifting attitude by managers.
    Keywords: Executive Compensation, Risk Taking, Financial Regulation, Monitoring.
    JEL: G21 G38
    Date: 2014–10–08
  7. By: David E. Allen; Michael McAleer (University of Canterbury); Robert J. Powell; Abhay K. Singh
    Abstract: This paper features an analysis of the effectiveness of a range of portfolio diversification strategies as applied to a set of daily arithmetically compounded returns on a set of ten market indices representing the major European markets for a nine year period from the beginning of 2005 to the end of 2013. The sample period, which incorporates the periods of both the Global Financial Crisis (GFC) and subsequent European Debt Crisis (EDC), is challenging one for the application of portfolio investment strategies. The analysis is undertaken via the examination of multiple investment strategies and a variety of hold-out periods and back-tests. We commence by using four two year estimation periods and subsequent one year investment hold out period, to analyse a naive 1/N diversification strategy, and to contrast its effectiveness with Markowitz mean variance analysis with positive weights. Markowitz optimisation is then compared with various down-side investment opimisation strategies. We begin by comparing Markowitz with CVaR, and then proceed to evaluate the relative effectiveness of Markowitz with various draw-down strategies, utilising a series of backtests. Our results suggest that none of the more sophisticated optimisation strategies appear to dominate naive diversification.
    Keywords: Portfolio Diversification, Markowitz Analaysis, Downside Risk, CVaR, Draw-down
    JEL: G11 C61
    Date: 2014–10–25
  8. By: Anna Zabai
    Abstract: High sovereign debt in advanced economies has recently revived the debate about the role of coordination problems and self-fulfilling beliefs as drivers of sovereign default risk. I show how default risk can be decomposed in a solvency-risk component and a coordination-risk component. I then study how fiscal policy can be effective in managing the risk of coordination and I characterise how the shape of the optimal policy is affected by the presence of this risk: making the deficit contingent on interest rate movements is more effective in managing default risk than using non-contingent fiscal targets.
    Keywords: Default risk, fiscal policy, coordination, global games.
    Date: 2014–10
  9. By: Juan C. Arismendi (ICMA Centre, Henley Business School, University of Reading); Herbert Kimura
    Abstract: An algorithm to generate samples with approximate first-, second-, and third-order moments is presented extending the Cholesky matrix decomposition to a Cholesky tensor decomposition of an arbitrary order. The tensor decomposition of the first-, second-, and third-order objective moments generates a non-linear system of equations. The algorithm solves these equations by numerical methods. The results show that the optimisation algorithm delivers samples with an approximate error of 0.1%–4% between the components of the objective and the sample moments. An application for sensitivity analysis of portfolio risk assessment with Value-at-Risk VaR) is provided. A comparison with previous methods available in the literature suggests that methodology proposed reduces the error of the objective moments in the generated samples
    Keywords: Monte Carlo Simulation, Higher-order Moments, Exact Moments Simulation, Stress-testing
    JEL: C14 C15 G32
    Date: 2014–08
  10. By: Cole, Shawn; Gine, Xavier; Vickery, James (Federal Reserve Bank of New York)
    Abstract: Weather is a key source of income risk, particularly in emerging market economies. This paper uses a randomized controlled trial involving a sample of Indian farmers to study how an innovative rainfall insurance product affects production decisions. We find that insurance provision induces farmers—particularly educated farmers—to shift production toward higher-return but higher-risk cash crops. Our results support the view that financial innovation can mitigate the real effects of uninsured production risk. Addressing the puzzle of low adoption, we show that payouts improve trust in the product and that farmers shield payouts from claims by relatives.
    Keywords: risk management; financial constraints
    JEL: G22 G32
    Date: 2014–09–01
  11. By: Craig, Ben R. (Federal Reserve Bank of Cleveland); Koetter, Michael (Frankfort School of Financial Management); Kruger, Ulrich (Deutsche Bundesbank)
    Abstract: We provide empirical evidence on the relevance of systemic risk through the interbank lending channel. We adapt a spatial probit model that allows for correlated error terms in the cross-sectional variation that depend on the measured network connections of the banks. The latter are in our application observed interbank exposures among German bank holding companies during 2001 and 2006. The results clearly indicate significant spillover effects between banks’ probabilities of distress and the financial profiles of connected peers. Better capitalized and managed connections reduce the banks own risk. Higher network centrality reduces the probability of distress, supporting the notion that more complete networks tend to be more stable. Finally, spatial autocorrelation is significant and negative. This last result may indicate too-many-to-fail mechanics such that bank distress is less likely if many peers already experienced distress.
    Keywords: Spatial Autoregression; interbank connections; bank risk
    JEL: E31 G21
    Date: 2014–10–02
  12. By: S. Tavolaro; F. Visnovsky
    Abstract: The SRISK measure is advertised as measuring the recapitalization needed by a financial institution in the event of a financial crisis. It is computed from the estimated reaction of the institution’s share price in the event of a sharp drop in market prices. This indicator relies both on an economic analysis and an econometric model. It is applied to a large set of international and domestic financial institutions, updated regularly and made available online. Although innovative, it stirred naturally debates among academics, supervisors and professionals, highlighting some limitations, in particular when considering the SRISK measure as a supervisory tool. First, the SRISK is based on market return data: consequently, it applies only to listed institutions and is exposed to criticisms as to which extent it can mirror fundamentals. Second, the SRISK seems to lack sound foundations for policy analysis: with a reduced-form approach, conclusions regarding causality are not obvious from an economic point of view. Moreover the SRISK is a conditional measure to an event whose likelihood is not integrated in the framework. Third, empirical analyses of SRISK as a supervisory tool, used for instance to identify systemic financial institutions (SIFIs) or as an early-warning indicator, have shown some limited perspectives.
    Keywords: Systemic Risk Measures, Market Data, Financial Monitoring.
    JEL: D81 L51 G01 G21 G28
    Date: 2014
  13. By: Bowo Setiyono (LAPE - Laboratoire d'Analyse et de Prospective Economique - Université de Limoges : EA1088 - Institut Sciences de l'Homme et de la Société); Amine Tarazi (LAPE - Laboratoire d'Analyse et de Prospective Economique - Université de Limoges : EA1088 - Institut Sciences de l'Homme et de la Société)
    Abstract: This study investigates the influence of background diversity of bank board members on performance and risk. Using data from Indonesian banks from 2001 to 2011 covering 4200 individual year observations and 21 ethnic groups, we estimate the degree of diversity by considering various aspects (gender, citizenship, age, experience, tenure, ethnicity, nationality, education level and type) and find significant impacts on bank performance. On the whole, diversity is in general positively associated with performance except when it relates to ethnicity. It not only reduces performance per se but also increases risk. Female presence and professional diversity reduce risk but nationality and ethnicity diversities are associated with higher risk. Education diversity generally leads to higher income volatility and leverage risk. Our results are generally robust to various alternative performance measures, including risk adjusted returns, and estimation methods.
    Keywords: Bank Board; Performance; Risk, Diversity; Ethnicity; Emerging Market
    Date: 2014–09–04
  14. By: Zhang Li; Xiaojun Lin; Borja Peleato-Inarrea; Ilya Pollak
    Abstract: This paper studies the problem of optimally allocating a cash injection into a financial system in distress. Given a one-period borrower-lender network in which all debts are due at the same time and have the same seniority, we address the problem of allocating a fixed amount of cash among the nodes to minimize the weighted sum of unpaid liabilities. Assuming all the loan amounts and asset values are fixed and that there are no bankruptcy costs, we show that this problem is equivalent to a linear program. We develop a duality-based distributed algorithm to solve it which is useful for applications where it is desirable to avoid centralized data gathering and computation. Since some applications require forecasting and planning for a wide variety of different contingencies, we also consider the problem of minimizing the expectation of the weighted sum of unpaid liabilities under the assumption that the net external asset holdings of all institutions are stochastic. We show that this problem is a two-stage stochastic linear program. To solve it, we develop two algorithms based on Monte Carlo sampling: Benders decomposition algorithm and projected stochastic gradient descent. We show that if the defaulting nodes never pay anything, the deterministic optimal cash injection allocation problem is an NP-hard mixed-integer linear program. However, modern optimization software enables the computation of very accurate solutions to this problem on a personal computer in a few seconds for network sizes comparable with the size of the US banking system. In addition, we address the problem of allocating the cash injection amount so as to minimize the number of nodes in default. For this problem, we develop a heuristic algorithm which uses reweighted l1 minimization. We show through numerical simulations that the solutions calculated by our algorithm are close to optimal.
    Date: 2014–10

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