nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒11‒17
eighteen papers chosen by

  1. Taking the risk out of systemic risk measurement I By Paul H. Kupiec; Levent Guntay
  2. TENET: Tail-Event driven NETwork risk By Wolfgang Karl Härdle; Natalia Sirotko-Sibirskaya; Weining Wang;
  3. Risk measures with the CxLS property By Freddy Delbaen; Fabio Bellini; Valeria Bignozzi; Johanna F. Ziegel
  4. Managing Banking Risk with the Risk Appetite Framework: a Quantitative Model for the Italian Banking System. By Baldan, Cinzia; Geretto, Enrico; Zen, Francesco
  5. Modelling cross-border systemic risk in the European banking sector: a copula approach By Raffaella Calabrese; Silvia Osmetti
  6. Risk Measurement and Risk Modelling using Applications of Vine Copulas By David E. Allen; Michael McAleer; Abhay K. Singh
  7. Incentive compensation for risk managers when effort is unobservable By Paul H. Kupiec
  8. Macro Stress-Testing Credit Risk in Romanian Banking System By Ruja, Catalin
  9. Hedging and Pricing in Imperfect Markets under Non-Convexity By Assa, Hirbod; Gospodinov, Nikolay
  10. The risk of financial intermediaries By Delis , Manthos D.; Hasan, Iftekhar; Tsionas, Efthymios G.
  11. The Individually Accepted Loss By Erick W. Rengifo; Debra Emanuela Trifan; Debra Rossen Trendafilov
  12. Improving Density Forecasts and Value-at-Risk Estimates by Combining Densities By Anne Opschoor; Dick van Dijk; Michel van der Wel
  13. Bank Capital Requirements and Mandatory Deferral of Compensation By Feess, Eberhard; Wohlschlegel, Ansgar
  14. The effects of ratings-contingent regulation on international bank lending behavior: Evidence from the Basel 2 accord By Hasan, Iftekhar; Kim, Suk-Joong; Wu , Eliza
  15. Capital Adequacy and Liquidity in Banking Dynamics: Theory and Regulatory Implications By Cao, Jin; Chollete, Loran
  16. The analytical framework for identifying and benchmarking systemically important financial institutions in Europe By Karkowska, Renata
  17. Incorporating Views on Marginal Distributions in the Calibration of Risk Models By Santanu Dey; Sandeep Juneja; Karthyek R. A. Murthy
  18. On Stochastic Orders and its applications : Policy limits and Deductibles By Halim Zeghdoudi; Meriem Bouhadjar; Mohamed Riad Remita

  1. By: Paul H. Kupiec (American Enterprise Institute); Levent Guntay (American Enterprise Institute)
    Abstract: An emerging literature proposes using conditional value at risk and marginal expected shortfall to measure financial institution systemic risk. We identify two weaknesses in this literature: (1) it lacks formal statistical hypothesis tests; and, (2) it confounds systemic and systematic risk. We address these weaknesses by introducing a null hypothesis that stock returns are normally distributed.
    Keywords: AEI Economic Policy Working Paper Series
    JEL: G
    Date: 2014–01
  2. By: Wolfgang Karl Härdle; Natalia Sirotko-Sibirskaya; Weining Wang;
    Abstract: We propose a semiparametric measure to estimate systemic interconnectedness across financial institutions based on tail-driven spill-over effects in a ultra-high dimensional framework. Methodologically, we employ a variable selection technique in a time series setting in the context of a single-index model for a generalized quantile regression framework. We can thus include more financial institutions into the analysis, to measure their interdependencies in tails and, at the same time, to take into account non-linear relationships between them. A empirical application on a set of 200 publicly traded U. S. nancial institutions provides useful rankings of systemic exposure and systemic contribution at various stages of financial crisis. Network analysis, its behaviour and dynamics, allows us to characterize a role of each sector in the financial crisis and yields a new perspective of the nancial markets at the U. S. financial market 2007 - 2012.
    Keywords: Systemic Risk, Systemic Risk Network, Generalized Quantile, Quantile Single-Index Regression, Value at Risk, CoVaR, Lasso
    JEL: G01 G18 G32 G38 C21 C51 C63
    Date: 2014–12
  3. By: Freddy Delbaen; Fabio Bellini; Valeria Bignozzi; Johanna F. Ziegel
    Abstract: In the present contribution we characterize law determined convex risk measures that have convex level sets at the level of distributions. By relaxing the assumptions in Weber (2006), we show that these risk measures can be identified with a class of generalized shortfall risk measures. As a direct consequence, we are able to extend the results in Ziegel (2014) and Bellini and Bignozzi (2014) on convex elicitable risk measures and confirm that expectiles are the only elicitable coherent risk measures. Further, we provide a simple characterization of robustness for convex risk measures in terms of a weak notion of mixture continuity.
    Date: 2014–11
  4. By: Baldan, Cinzia; Geretto, Enrico; Zen, Francesco
    Abstract: We analyse the structural aspects of the banking Risk Appetite Framework (RAF), providing an operational application in the light of the detailed recommendations of the banking supervisors. We develop a quantitative approach that could be used to adapt to the requirements of these regulations and that might be useful for management purposes. This approach is empirically applied to the balance sheets of the Italian banking system. Our findings show that the Italian banks are generally underexposed in terms of credit risk and market risk, so there is room for shifting the risk profiles towards higher thresholds with a view to improving the credit institutions’ profitability while keeping their RAF consistent with the regulatory bodies’ requirements. The quantitative model can be applied effectively to all banks, for different types of risk, making the necessary adjustments according to the particular features of the profile being examined.
    Keywords: Banks; Risk Appetite Framework; Risk Management
    JEL: C43 G20 G21
    Date: 2014–10
  5. By: Raffaella Calabrese; Silvia Osmetti
    Abstract: We propose a new methodology based on the Marshall-Olkin (MO) copula to model cross-border systemic risk. The proposed framework estimates the impact of the systematic and idiosyncratic components on systemic risk. Initially, we propose a maximum-likelihood method to estimate the parameter of the MO copula. In order to use the data on non-distressed banks for these estimates, we consider times to bank failures as censored samples. Hence, we propose an estimation procedure for the MO copula on censored data. The empirical evidence from European banks shows that the proposed censored model avoid possible underestimation of the contagion risk.
    Date: 2014–11
  6. By: David E. Allen (School of Mathematics and Statistics, Sydney University, NSW, and Centre for Applied Financial Studies, University of South Australia, Adelaide, SA, Australia); Michael McAleer (National Tsing Hua University, Taiwan, and Econometric Institute, Erasmus School of Economics, Erasmus University Rotterdam, and Tinbergen Institute, the Netherlands, and Department of Quantitative Economics, Complutense University of Madrid, Spain); Abhay K. Singh (School of Business, Edith Cowan University, Joondalup, WA, Australia)
    Abstract: This paper features an application of Regular Vine copulas which are a novel and recently developed statistical and mathematical tool which can be applied in the assessment of composite nancial risk. Copula-based dependence modelling is a popular tool in nancial applications, but is usually applied to pairs of securities. By contrast, Vine copulas provide greater exibility and permit the modelling of complex dependency patterns using the rich variety of bivariate copulas which may be arranged and analysed in a tree structure to explore multiple dependencies. The paper features the use of Regular Vine copulas in an analysis of the co-dependencies of 10 major European Stock Markets, as represented by individual market indices and the composite STOXX 50 index. The sample runs from 2005 to the end of 2011 to permit an exploration of how correlations change indierent economic circumstances using three dierent sample periods: pre-GFC pre-GFC (Jan 2005- July 2007), GFC (July 2007-Sep 2009), and post-GFC periods (Sep 2009 - Dec 2011). The empirical results suggest that the dependencies change in a complex manner, and are subject to change in dierent economic circumstances. One of the attractions of this approach to risk modelling is the exibility in the choice of distributions used to model co-dependencies. The practical application of Regular Vine metrics is demonstrated via an example of the calculation of the VaR of a portfolio made up of the indices.
    Keywords: Regular Vine Copulas, Tree structures, Co-dependence modelling, European stock markets
    JEL: G11 C02
    Date: 2014–05–08
  7. By: Paul H. Kupiec (American Enterprise Institute)
    Abstract: In a financial intermediary, risk managers can expend effort to reduce loan probability of default and loss given default, but effort is unobservable. Incentive compensation (IC) can induce manager effort. When deposit insurance is subsidized, the demand for risk management declines. Regulatory policy should then reinforce incentives to offer risk mangers appropriate IC contracts.
    Keywords: AEI Economic Policy Working Paper Series, Financial services
    JEL: G
    Date: 2013–10
  8. By: Ruja, Catalin
    Abstract: This report presents an application of a macro stress testing procedure on credit risk in the Romanian banking system. Macro stress testing, i.e. assessing the vulnerability of financial systems to exceptional but plausible macroeconomic scenarios, maintains a central role in macro-prudential and crisis management frameworks of central banks and international institutions around the globe. Credit risk remains the dominant risk challenging financial stability in the Romanian financial system, and thus this report analyses the potential impact of macroeconomic shocks scenarios on default rates in the corporate and household loan portfolios in the domestic banking system. A well-established reduced form model is proposed and tested as the core component of the modelling approach. The resulting models generally confirm the influence of macroeconomic factors on credit risk as documented in previous research including applications for Romania, but convey also specific and novel findings, such as inclusion of leading variables and construction activity level for corporate credit risk. Using the estimated model, a stress testing simulation procedure is undertaken. The simulation shows that under adverse shock scenarios, corporate default rates can increase substantially more than the expected evolution under the baseline scenario, especially in case of GDP shock, construction activity shock or interest rate shocks. Under the assumptions of these adverse scenarios, given also the large share of corporate loans in the banks’ balance sheet, the default rates evolution could have a substantial impact on banks’ loan losses. The households sector stress testing simulation show that this sector is more resilient to macroeconomic adverse evolutions, with stressed default rates higher than expected values under baseline scenario, but with substantially lower deviations. The proposed macro-perspective model and its findings can be incorporated by private banks in their micro-level portfolio risk management tools. Additionally, supplementing the authorities’ stress tests with independent approaches can enhance credibility of such financial stability assessment.
    Keywords: Stress Testing, Macro Stress Testing, Credit Risk, Banking Crisis, Monte Carlo simulation, Romania
    JEL: C01 C12 C13 C15 C32 C52 C53 C87 E58 G01 G21
    Date: 2014–07–23
  9. By: Assa, Hirbod (University of Liverpool); Gospodinov, Nikolay (Federal Reserve Bank of Atlanta)
    Abstract: This paper proposes a robust approach to hedging and pricing in the presence of market imperfections such as market incompleteness and frictions. The generality of this framework allows us to conduct an in-depth theoretical analysis of hedging strategies for a wide family of risk measures and pricing rules, which are possibly non-convex. The practical implications of our proposed theoretical approach are illustrated with an application on hedging economic risk.
    Keywords: imperfect markets; risk measures; hedging; pricing rule; quantile regression
    JEL: C22 E44 G11 G13
    Date: 2014–08–01
  10. By: Delis , Manthos D. (University of Surrey); Hasan, Iftekhar (Fordham University and Bank of Finland); Tsionas, Efthymios G. (Lancaster University Management School)
    Abstract: This paper reconsiders the formal estimation of bank risk using the variability of the profit function. In our model, point estimates of the variability of profits are derived from a model where this variability is endogenous to other bank characteristics, such as capital and liquidity. We estimate the new model on the entire panel of US banks, spanning the period 1985q1–2012q4. The findings show that bank risk was fairly stable up to 2001 and accelerated quickly thereafter up to 2007. We also establish that the risk of the relatively large banks and banks that failed in the subprime crisis is higher than the industry’s average. Thus, we provide a new leading indicator, which is able to forecast future solvency problems of banks.
    Keywords: estimation of risk; profit function; financial institutions; banks; endogenous risk; US banking sector
    JEL: C13 C33 E47 G21 G32
    Date: 2014–07–09
  11. By: Erick W. Rengifo (Fordham University); Debra Emanuela Trifan (Bayerngas Energy); Debra Rossen Trendafilov (Truman State University)
    Abstract: This paper proposes a new, individual measure of market risk, denoted as the individually acceptable loss (IAL). This measure can be used by portfolio managers in order to better meet the individual profiles of their non-professional clients, including phsychological traits. It can be easily assessed from general subjective and objective parameters. We formally define the IAL of loss averse investors, who narrowly frame financial investments, and are sensitive to the past performance of their risky portfolio. This individual risk measue is applied to the classic portfolio optimization framework in order to derive the optimal wealth allocation among different financial assets. our empirical results suggest that previous optimization relying on a portfolio-exogenous VaR-formulation, underestimates the aversion of individual investors towards financial losses.
    Keywords: market risk, prospect theory, loss aversion, capital allocation, Value-at-Risk.
    JEL: C32 C35 G10
    Date: 2014
  12. By: Anne Opschoor (VU University Amsterdam); Dick van Dijk (Erasmus University Rotterdam); Michel van der Wel (Erasmus University Rotterdam)
    Abstract: We investigate the added value of combining density forecasts for asset return prediction in a specific region of support. We develop a new technique that takes into account model uncertainty by assigning weights to individual predictive densities using a scoring rule based on the censored likelihood. We apply this approach in the context of recently developed univariate volatility models (including HEAVY and Realized GARCH models), using daily returns from the S&P 500, DJIA, FTSE and Nikkei stock market indexes from 2000 until 2013. The results show that combined density forecasts based on the censored likelihood scoring rule significantly outperform pooling based on the log scoring rule and individual density forecasts. The same result, albeit less strong, holds when compared to combined density forecasts based on equal weights. In addition, VaR estimates improve a t the short horizon, in particular when compared to estimates based on equal weights or to the VaR estimates of the individual models.
    Keywords: Density forecast evaluation, Volatility modeling, Censored likelihood, Value-at-Risk
    JEL: C53 C58 G17
    Date: 2014–07–21
  13. By: Feess, Eberhard; Wohlschlegel, Ansgar
    Abstract: Tighter capital requirements and mandatory deferral of compensation are among the most prominently advocated regulatory measures to reduce excessive risk-taking in the banking industry. We analyze the interplay of the two instruments in an economy with two heterogenous banks that can fund uncorrelated projects with fully diversifiable risk or correlated projects with systemic risk. If both project types are in abundant supply, we find that full mandatory deferral of compensation is beneficial as it allows for weaker capital requirements, and hence for a larger banking sector, without increasing the incentives for risk-shifting. With competition for uncorrelated projects, however, deferred compensation may misallocate correlated projects to the bank which is inferior in managing risks. Our findings challenge the current tendency to impose stricter regulations on more sophisticated institutes.
    Keywords: Bank capital requirements; deferred bonuses; risk-shifting; financial crisis; executive compensation
    JEL: D62 G21 G28 J33
    Date: 2014–07–23
  14. By: Hasan, Iftekhar (Fordham University and Bank of Finland); Kim, Suk-Joong (University of Sydney); Wu , Eliza (University of Technology Sydney)
    Abstract: We investigate the effects of credit ratings-contingent financial regulation on foreign bank lending behavior. We examine the sensitivity of international bank flows to debtor countries’ sovereign credit rating changes before and after the implementation of the Basel 2 risk-based capital regulatory rules. We study the quarterly bilateral flows from G-10 creditor banking systems to 77 recipient countries over the period Q4:1999 to Q2:2013. We find direct evidence that sovereign credit re-ratings that lead to changes in risk-weights for capital adequacy requirements have become more significant since the implementation of Basel 2 rules for assessing banks’ credit risk under the standardized approach. This evidence is consistent with global banks acting via their international lending decisions to minimize required capital charges associated with the use of ratings-contingent regulation. We find evidence that banking regulation induced foreign lending has also heightened the perceived sovereign risk levels of recipient countries, especially those with investment grade status.
    Keywords: cross-border banking; sovereign credit ratings; Basel 2; rating-contingent financial regulation
    JEL: E44 F34 G21 H63
    Date: 2014–09–21
  15. By: Cao, Jin (Norges Bank); Chollete, Loran (UiS)
    Abstract: We present a framework for modelling optimum capital adequacy in a dynamic banking context. We combine the (static) capital adequacy framework of Repullo (2013) with a dynamic banking model similar to that of Corbae and D`Erasmo (2014), with the extra feature that the probability of systemic risk is endogenous. Unlike previous work, we examine frameworks to ameliorate bankruptcy using both capital adequacy and liquidity requirements. Since equity is costly, the social cost of regulation may be reduced if a regulatory capital requirement can be accompanied by other tools such as a liquidity buffer.
    Keywords: Keywords: Bankruptcy; Capital Adequacy; Endogenous Systemic Risk; Liquidity Requirement; Regulation Costs
    JEL: E50 G21 G28
    Date: 2014–09–16
  16. By: Karkowska, Renata
    Abstract: The aim of this article is to identify systemically important banks on a European scale, in accordance with the criteria proposed by the supervisory authorities. In this study we discuss the analytical framework for identifying and benchmarking systemically important financial institutions. An attempt to define systemically important institutions is specified their characteristics under the existing and proposed regulations. In a selected group of the largest banks in Europe the following indicators ie.: leverage, liquidity, capital ratio, asset quality and profitability are analyzed as a source of systemic risk. These figures will be confronted with the average value obtained in the whole group of commercial banks in Europe. It should help finding the answer to the question, whether the size of the institution generates higher systemic risk? The survey will be conducted on the basis of the financial statements of commercial banks in 2007 and 2010 with the available statistical tools, which should reveal the variability of risk indicators over time. We find that the largest European banks were characterized by relative safety and without excessive risk in their activities. Therefore, a fundamental feature of increased regulatory limiting systemic risk should understand the nature and sources of instability, and mobilizing financial institutions (large and small) to change their risk profile and business models in a way that reduces the instability of the financial system globally.
    Keywords: banking, Systematically Important Financial Institutions, SIFI, systemic risk, liquidity, leverage, profitability
    JEL: C1 F36 G21 G32 G33
    Date: 2014–09
  17. By: Santanu Dey; Sandeep Juneja; Karthyek R. A. Murthy
    Abstract: Entropy based ideas find wide-ranging applications in finance for calibrating models of portfolio risk as well as options pricing. The abstracted problem, extensively studied in the literature, corresponds to finding a probability measure that minimizes relative entropy with respect to a specified measure while satisfying constraints on moments of associated random variables. These moments may correspond to views held by experts in the portfolio risk setting and to market prices of liquid options for options pricing models. However, it is reasonable that in the former settings, the experts may have views on tails of risks of some securities. Similarly, in options pricing, significant literature focuses on arriving at the implied risk neutral density of benchmark instruments through observed market prices. With the intent of calibrating models to these more general stipulations, we develop a unified entropy based methodology to allow constraints on both moments as well as marginal distributions of functions of underlying securities. This is applied to Markowitz portfolio framework, where a view that a particular portfolio incurs heavy tailed losses is shown to lead to fatter and more reasonable tails for losses of component securities. We also use this methodology to price non-traded options using market information such as observed option prices and implied risk neutral densities of benchmark instruments.
    Date: 2014–11
  18. By: Halim Zeghdoudi; Meriem Bouhadjar; Mohamed Riad Remita
    Abstract: This paper focuses on stochastic orders and its applications : policy limits and deductibles. Further, many applications and some examples are given : comparison of two families of copulas, individual and collective risk model, reinsurance contracts and dependent portfolios increase risk. More precisely, we propose a new model for insurance risks while we give some properties. To this end, we obtain the ordering of the optimal allocation of policy limits and deductibles for this model.
    Date: 2014–11

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