nep-rmg New Economics Papers
on Risk Management
Issue of 2015‒01‒03
fourteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Regulatory Capital Modelling for Credit Risk By Marek Rutkowski; Silvio Tarca
  2. Operational Risk Governance: The Basel Approach By Afanasyeva, Olga; Riabichenko, Dmitry
  3. Risk minimization and portfolio diversification By Farzad Pourbabaee; Minsuk Kwak; Traian A. Pirvu
  4. "Volatility and Quantile Forecasts by Realized Stochastic Volatility Models with Generalized Hyperbolic Distribution" By Makoto Takahashi; Toshiaki Watanabe; Yasuhiro Omori
  5. The risk of self-protection: the role of bank bailout guarantees in channelling sovereign credit risk internationally By filippo gori
  6. Pro-cyclical capital regulation and lending By Behn, Markus; Haselmann, Rainer; Wachtel, Paul
  7. What drives investment bank performance? the role of risk, liquidity and fees prior to and during the crisis. By Mamatzakis, E; bermpei, t
  8. Shadow Insurance By Yogo, Motohiro; Koijen, Ralph S.J.
  9. The effects of disclosure policy on risk management incentives and market entry By Hoang, Daniel; Ruckes, Martin
  10. Estimation and Determinants of Chinese Banks’ Total Factor Efficiency: A New Vision Based on Unbalanced Development of Chinese Banks and Their Overall Risk By Shiyi Chen; Wolfgang K. Härdle; Li Wang;
  11. A Transitions-Based Model of Default for Irish Mortgages By Kelly, Robert; O'Malley, Terence
  12. European option pricing with constant relative sensitivity probability weighting function By Martina Nardon; Paolo Pianca
  13. Equity Recourse Notes: Creating Counter-cyclical Bank Capital By Bulow, Jeremy I.; Klemperer, Paul
  14. Why is too much leverage bad for the economy? By Felix Kubler; John Geanakoplos

  1. By: Marek Rutkowski; Silvio Tarca
    Abstract: The Basel II internal ratings-based (IRB) approach to capital adequacy for credit risk plays an important role in protecting the Australian banking sector against insolvency. We outline the mathematical foundations of regulatory capital for credit risk, and extend the model specification of the IRB approach to a more general setting than the usual Gaussian case. It rests on the proposition that quantiles of the distribution of conditional expectation of portfolio percentage loss may be substituted for quantiles of the portfolio loss distribution. We present a more economical proof of this proposition under weaker assumptions. Then, constructing a portfolio that is representative of credit exposures of the Australian banking sector, we measure the rate of convergence, in terms of number of obligors, of empirical loss distributions to the asymptotic (infinitely fine-grained) portfolio loss distribution. Moreover, we evaluate the sensitivity of credit risk capital to dependence structure as modelled by asset correlations and elliptical copulas. Access to internal bank data collected by the prudential regulator distinguishes our research from other empirical studies on the IRB approach.
    Date: 2014–12
  2. By: Afanasyeva, Olga; Riabichenko, Dmitry
    Abstract: This paper analyses key documents of Basel Committee which concern operational risk governance and identifies the interconnectedness between risk source, type of the event leading to losses, loss type and its distribution by business lines. The comparative characteristic of the main operational risk governance stages is provided and the relationships between governance bodies are overviewed.
    Keywords: operational risk, corporate governance, Basel Committee on Banking Supervision, board of directors, banking
    JEL: E5 E58 G2
    Date: 2014
  3. By: Farzad Pourbabaee; Minsuk Kwak; Traian A. Pirvu
    Abstract: We consider the problem of minimizing capital at risk in the Black-Scholes setting. The portfolio problem is studied given the possibility that a correlation constraint between the portfolio and a financial index is imposed. The optimal portfolio is obtained in closed form. The effects of the correlation constraint are explored; it turns out that this portfolio constraint leads to a more diversified portfolio.
    Date: 2014–11
  4. By: Makoto Takahashi (Center for the Study of Finance and Insurance, Osaka University); Toshiaki Watanabe (Institute of Economic Research, Hitotsubashi University); Yasuhiro Omori (Faculty of Economics, The University of Tokyo)
    Abstract: The realized stochastic volatility model of Takahashi, Omori, and Watanabe (2009), which incorporates the asymmetric stochastic volatility model with the realized volatility, is extended by employing a wider class distribution, the generalized hyperbolic skew Student's t-distribution, for nancial returns. The extension makes it possible to consider the heavy tail and skewness in nancial returns. With the Bayesian estimation scheme via Markov chain Monte Carlo method, the model enables us to estimate the parameters in the return distribution and in the model jointly. It also makes it possible to forecast volatility and return quantiles by sampling from their posterior distributions jointly. The model is applied to quantile forecasts of nancial returns such as value-at-risk and expected shortfall as well as volatility forecasts and those forecasts are evaluated by several backtesting procedures. Empirical results with the US index, Dow Jones Industrial Average, show that the extended model ts the data better and improves the volatility and quantile forecasts.
    Date: 2014–12
  5. By: filippo gori (IHEID, The Graduate Institute of International and Development Studies, Geneva)
    Abstract: This paper investigates the role of banks’ foreign asset holdings in transmitting credit risk internationally. Foreign exposure in risky assets might severely affect the solvability of credit institutions. Credit risk, in turn, transfers from banks to public accounts as a consequence of implicit or explicit bailout guarantees to distressed banking systems. This paper articulates this mechanism with a simple model where governments choose to fill banks' capital gaps to self-protect from the severe economic consequence of a banking sector default. Referring to the existing literature on the determinants of sovereign yield spreads in the second part of the paper, I present empirical evidence of the link between banks’ foreign claims and countries' credit risk. Results for the eurozone identify banks' foreign exposure as a major determinant of sovereign default probability. Also, governments' vulnerability to credit risk spill over decreases with banks' capitalisation and sovereigns' fiscal solvability of credit institutions. Credit risk, in turn, transfers from banks to public accounts as a consequence of implicit or explicit bailout guarantees to distressed banking systems. This paper articulates this mechanism with a simple model where governments choose to fill banks' capital gaps to self-protect from the severe economic consequence of a banking sector default. Referring to the existing literature on the determinants of sovereign yield spreads in the second part of the paper, I present empirical evidence of the link between banks’ foreign claims and countries' credit risk. Results for the eurozone identify banks' foreign exposure as a major determinant of sovereign default probability. Also, governments' vulnerability to credit risk spill over decreases with banks' capitalisation and sovereigns' fiscal soundness.undness.
    Keywords: Banks, Sovereign Credit Risk,International Spillover
    JEL: G15 F36 G28
    Date: 2012–11–05
  6. By: Behn, Markus; Haselmann, Rainer; Wachtel, Paul
    Abstract: We use a quasi-experimental research design to examine the effect of model-based capital regulation introduced under the Basel II agreement on the pro-cyclicality of bank lending and firms' access to funds during a recession. In response to an exogenous shock to credit risk in the German economy, loans subject to modelbased, time-varying capital charges were reduced by 3.5 percent more than loans under the traditional approach to capital regulation. The effect is even stronger when we examine aggregate firm borrowing, suggesting that the pro-cyclical effect of model-based capital charges is not offset by substitution to other banks which use the traditional approach.
    Keywords: capital regulation,credit crunch,financial crisis
    JEL: G01 G21 G28
    Date: 2014
  7. By: Mamatzakis, E; bermpei, t
    Abstract: This paper examines factors that affect the performance of investment banks in the G7 and Switzerland. In particular, we focus on the role of risk, liquidity and investment banking fees. Panel analysis shows that those variables significantly impact upon performance as derived from stochastic frontier analysis (SFA). Given our sample also comprises the financial crisis, we further test for regimes switches using dynamic panel threshold analysis. Results show different underlying regimes, in particular over the financial crisis. In addition, a strong positive effect of Z-Score on performance for banks in the regime of low default risk is reported, whilst fee-income ratio has also a positive impact for banks with low level of fees. On the other hand, liquidity exerts a negative impact. Notably, there is a clear trend of mobility of banks across the two identified threshold regimes with regards to risk a year before the financial crisis. Our results provide evidence that recent regulation reforms regarding capital adequacy and liquidity requirements are on the right track and could enhance performance.
    Keywords: Investment Banking, Risk, Liquidity, Fees, Dynamic Panel Threshold Analysis.
    JEL: G1 G18 G21
    Date: 2014–11–14
  8. By: Yogo, Motohiro (Federal Reserve Bank of Minneapolis); Koijen, Ralph S.J. (London Business School)
    Abstract: Liabilities ceded by life insurers to shadow reinsurers (i.e., affiliated and less regulated off-balance-sheet entities) grew from $11 billion in 2002 to $364 billion in 2012. Life insurers using shadow insurance, which capture half of the market share, ceded 25 cents of every dollar insured to shadow reinsurers in 2012, up from 2 cents in 2002. Our adjustment for shadow insurance reduces risk-based capital by 53 percentage points (or 3 rating notches) and raises default probabilities by a factor of 3.5. We develop a structural model of the life insurance industry and estimate the impact of current policy proposals to contain or eliminate shadow insurance. In the counterfactual without shadow insurance, the average company currently using shadow insurance would raise its price by 12 percent, and annual life insurance underwritten would fall by 11 percent for the industry.
    Keywords: Capital regulation; Life insurance industry; Regulatory arbitrage; Reinsurance; Special purpose vehicles
    JEL: G22 G28 L11 L51
    Date: 2014–11–26
  9. By: Hoang, Daniel; Ruckes, Martin
    Abstract: This paper studies the effects of hedge disclosure requirements on corporate risk management and product market competition. The analysis is based on a simple model of market entry and shows that incumbent firms engage in risk management when these activities remain unobserved by outsiders. The resulting equilibrium is desirable from a social standpoint. Financial markets are well informed and entry is efficient. However, potential attempts for more transparency by additional disclosure requirements introduce a commitment device that provides firms with incentives to distort risk management activities thereby influencing entrant beliefs. In equililibrium, firms engage in significant risk-taking. This behavior limits entry and adversely affects the nature of competition in industries. Our findings thus suggest that more disclosure on risk management may change risk management in socially undesirable ways.
    Keywords: Risk Management,Hedge Disclosures,Market Entry,Signal Jamming
    JEL: D82 G3 L1 M4
    Date: 2014
  10. By: Shiyi Chen; Wolfgang K. Härdle; Li Wang;
    Abstract: The development of shadow banking system in China catalyzes the expansion of banks’ off-balance-sheet activities, resulting in a distortion of China’s traditional credit expansion and underestimation of its commercial banks’ overall risk. This paper is the first to incorporate banks’ overall risk, endogenously into bank’s production process as undesirable by-product for the estimation of banks’ total factor efficiency (TFE) as well as TFE of each production factor. A unique data sample of 171 Chinese commercial banks, which is the largest data sample concerning with Chinese banking efficiency issues until now as far as we know, making our results more convincing and meaningful. Our results show that, compared with a model incorporated with banks’ overall risk, a model considering on-balance-sheet lending activities only may over-estimate the overall average TFE and under-estimate TFE volatility as a whole. Higher overall risk taking of banks tends to decrease bank TFE through ‘diverting effect’. However, significant heterogeneities of bank integrated TFE (TFIE) and TFE of each production factor exist among banks of different types or located in different regions, as a result of still prominent unbalanced development of Chinese commercial banks today. Based on newly estimated TFIE, the paper also investigates the determinants of bank efficiency, and finds that a model with risk-weighted assets as undesirable outputs can better capture the impact of shadow banking involvement.
    Keywords: Total Factor Efficiency, Unbalanced Development, Shadow Banking, Global SBM
    JEL: C14 C33 G21
    Date: 2014–11
  11. By: Kelly, Robert (Central Bank of Ireland); O'Malley, Terence (Central Bank of Ireland)
    Abstract: Using a uniquely constructed loan-level dataset of the residential mortgage book of Irish financial institutions, this paper provides a framework for estimating default probabilities of individual mort- gages. In contrast to the popular stock delinquency approach, this model provides estimates of default and cure ows: a requirement of the stress test approach adopted by the European Central Bank's comprehensive assessment. In addition, both default and cure transitions are modelled as functions of micro- and macro-covariates including loan characteristics and current macroeconomic conditions such as house prices and unemployment. When comparing the competing equity and affordability effects, labour market deterioration played a stronger role than house equity in the rise of Irish default rates. For cures, a scarring effect of default is identified and estimated with the probability of a loan returning to performing reducing by 25 per cent each quarter a loan remains delinquent.
    Keywords: Mortgage Default Modelling, Irish Banks, ECB Comprehensive Assessment.
    JEL: G01 G12 G21
    Date: 2014–11
  12. By: Martina Nardon (Department of Economics, Cà Foscari University Of Venice); Paolo Pianca (Department of Economics, Cà Foscari University Of Venice)
    Abstract: We evaluate European financial options under continuous cumulative prospect theory. Within this framework, it is possible to model investors’ attitude toward risk, which may be one of the possible causes of mispricing. We focus on probability risk attitudes and consider alternative probability weighting functions. In particular, curvature of the weighting function models optimism and pessimism when one moves from extreme probabilities, whereas elevation can be interpreted as a measure of relative optimism. The constant relative sensitivity weighting function is the only one, amongst those in the literature, which is able to model separately curvature and elevation. We are interested in studying the effects of both these features on options prices.
    Keywords: C63, D81, G13
  13. By: Bulow, Jeremy I.; Klemperer, Paul
    Abstract: We propose a new form of hybrid capital for banks, Equity Recourse Notes (ERNs), which ameliorate booms and busts by creating counter-cyclical incentives for banks to raise capital, and so encourage bank lending in bad times. They avoid the flaws of existing contingent convertible bonds (cocos)--in particular, they convert more credibly--so ERNs also help solve the too-big-to-fail problem: rather than forcing banks to increase equity, we should require the same or larger capital increase but permit it to be in the form of either equity or ERNs--this also gives some choice to those who claim (rightly or wrongly) that equity is more costly than debt. ERNs can be introduced within the current regulatory system, but also provide a way to reduce the existing system’s heavy reliance on measures of regulatory-capital.
    Keywords: bail-in; bank; bank capital; capital requirements; coco; contingent capital; contingent convertible bond; SIFI
    JEL: G10 G21 G28 G32
    Date: 2014–10
  14. By: Felix Kubler (University of Zurich and SFI); John Geanakoplos (Yale University)
    Abstract: To illustrate the first mechanism we present a very simple example without collateral and default where restricting borrowing leads to a Pareto-improvement over the competitive equilib- rium allocation because financial markets are incomplete. Limiting borrowing naturally leads to a change in spot-prices that makes all agents better off. We then introduce collateral, default, endogenous margin requirements and production and we illustrate the second mechanism by showing that the endogenous margin requirements are suboptimal because they result in too much default. Finally we show how the two effects interact - forcing agents to leverage less leads to a Pareto-improvement because it reduces default and because it reduces borrowing.
    Date: 2014

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