nep-rmg New Economics Papers
on Risk Management
Issue of 2017‒09‒03
twenty papers chosen by
Stan Miles
Thompson Rivers University

  1. The systemic risk of central SIFIs By Cathy Yi-Hsuan Chen; Sergey Nasekin;
  2. The Z-score is dead, long live the Z-score! A new way to measure bank risk By Ion Lapteacru
  3. Value-at-Risk and Expected Shortfall for the major digital currencies By Stavros Stavroyiannis
  4. Optimal insurance for catastrophic risk: theory and application to nuclear corporate liability By Alexis Louaas; Pierre Picard
  5. Pricing formulae for derivatives in insurance using the Malliavin calculus * By Caroline Hillairet; Ying Jiao; Anthony Réveillac
  6. Abnormal loan growth, credit information sharing and systemic risk in Asian banks By Wahyoe Soedarmono; Djauhari Sitorus; Amine Tarazi
  7. Bank Liquidity Management and Bank Capital Shocks By Robert Deyoung; Isabelle Distinguin; Amine Tarazi
  8. Does banks' systemic importance affect their capital structure adjustment process? By Yassine Bakkar; Olivier De Jonghe; Amine Tarazi
  9. Haircutting Non-cash Collateral By Wujiang Lou
  10. Liquidity Policies and Systemic Risk By Adrian, Tobias; Boyarchenko, Nina
  11. Model-Based Measures of ELB Risk By Taisuke Nakata
  12. A Competing Risk Decomposition of Average Duration Effects By Donal O'Neill
  13. Measurement of Common Risk Factors: A Panel Quantile Regression Model for Returns By Frantisek Cech; Jozef Barunik
  14. Bank Profitability and Risk-Taking under Low Interest Rates By J.A. Bikker; Tobias M. Vervliet
  15. The stabilizing effect of volatility in financial markets By Davide Valenti; Giorgio Fazio; Bernardo Spagnolo
  16. American options in an imperfect market with default By Roxana Dumitrescu; Marie-Claire Quenez; Agn\`es Sulem
  17. Survey sponsor effects on the willingness to pay for mortality risk reductions By Marcelo Lima
  18. The regional pricing of risk: An empirical investigation of the MENA equity determinants By Khaled Guesmi; Sandrine Kablan; Aymen Belgacem
  19. Time-Varying Rare Disaster Risks, Oil Returns and Volatility By Rıza Demirer; Rangan Gupta; Tahir Suleman; Mark E. Wohar
  20. Combining Sharp and Smooth Transitions in Volatility Dynamics: a Fuzzy Regime Approach By Giampiero M. Gallo; Edoardo Otranto

  1. By: Cathy Yi-Hsuan Chen; Sergey Nasekin;
    Abstract: Systemic risk quantification in the current literature is concentrated on market-based methods such as CoVaR(Adrian and Brunnermeier (2016)). Although it is easily implemented, the interactions among the variables of interest and their joint distribution are less addressed. To quantify systemic risk in a system-wide perspective, we propose a network-based factor copula approach to study systemic risk in a network of systemically important financial institutions (SIFIs). The factor copula model offers a variety of dependencies/tail dependencies conditional on the chosen factor; thus constructing conditional network. Given the network, we identify the most “connected” SIFI as the central SIFI, and demonstrate that its systemic risk exceeds that of non-central SIFIs. Our identification of central SIFIs shows a coincidence with the bucket approach proposed by the Basel Committee on Banking Supervision, but places more emphasis on modeling the interplay among SIFIs in order to generate systemwide quantifications. The network defined by the tail dependence matrix is preferable to that defined by the Pearson correlation matrix since it confirms that the identified central SIFI through it severely impacts the system. This study contributes to quantifying and ranking the systemic importance of SIFIs.
    Keywords: factor copula, network, Value-at-Risk, tail dependence, eigenvector centrality JEL Classification: C00, C14, C50, C58
    JEL: C00 C14 C50 C58
    Date: 2017–08
  2. By: Ion Lapteacru (Larefi - Laboratoire d'analyse et de recherche en économie et finance internationales - Université Montesquieu - Bordeaux 4)
    Abstract: This paper raises questions about the consistency of the Z-score, which is the most applied accounting-based measure of bank risk. In spite of its main advantage, namely the concept of risk on which it relies, the traditional formula is precisely inconsistent with this concept. The Z-score is deduced from the probability that bank’s losses exceed its capital, but under the very unrealistic assumption of normally distributed returns on assets. Consequently, we propose a structural approach to determine this bank risk measure. It consists to define the default event when banks’ profit is lower than a default threshold level, which is based on the balance-sheet structure of banks and on new prudential regulation requirements.
    Keywords: Z-score, Bank risk, Banking
    Date: 2017–05–05
  3. By: Stavros Stavroyiannis
    Abstract: Digital currencies and cryptocurrencies have hesitantly started to penetrate the investors, and the next step will be the regulatory risk management framework. We examine the Value-at-Risk and Expected Shortfall properties for the major digital currencies, Bitcoin, Ethereum, Litecoin, and Ripple. The methodology used is GARCH modelling followed by Filtered Historical Simulation. We find that digital currencies are subject to a higher risk, therefore, to higher sufficient buffer and risk capital to cover potential losses.
    Date: 2017–08
  4. By: Alexis Louaas (Department of Economics, Ecole Polytechnique - Polytechnique - X - CNRS - Centre National de la Recherche Scientifique); Pierre Picard (Department of Economics, Ecole Polytechnique - Polytechnique - X - CNRS - Centre National de la Recherche Scientifique)
    Abstract: This paper analyzes the optimal insurance for low probability - high severity accidents, such as nuclear catastrophes, both from theoretical and applied standpoints. We show that the risk premium of such catastrophic events may be a non-negligible proportion of individuals’ wealth when the index of absolute risk aversion is sufficiently large in the accident state, and we characterize the optimal asymptotic insurance coverage when the probability of the accident tends to zero. In the case of the limited liability of an industrial firm that may cause large scale damage, the limit corporate insurance contract corresponds to a straight deductible indemnification rule, in which victims are ranked according to the severity of their losses. As an application of these general principles, we consider the optimal corporate liability insurance for nuclear risk, in a setting where the risk is transferred to financial markets through catastrophe bonds. A model calibrated with French data allows us to estimate the optimal liability of a nuclear energy producer. This leads us to the conclusion that the lower limit adopted in 2004 through the revision of the Paris Convention is probably inferior to the socially optimal level.
    Keywords: risk aversion, liability insurance, catastrophic risk,nuclear accident
    Date: 2017–05–24
  5. By: Caroline Hillairet (ENSAE ParisTech - École Nationale de la Statistique et de l'Administration Économique); Ying Jiao (SAF - Laboratoire de Sciences Actuarielle et Financière - UCBL - Université Claude Bernard Lyon 1); Anthony Réveillac (INSA Toulouse - Institut National des Sciences Appliquées - Toulouse, IMT - Institut de Mathématiques de Toulouse UMR5219 - UT1 - Université Toulouse 1 Capitole - UT2 - Université Toulouse 2 - UPS - Université Paul Sabatier - Toulouse 3 - PRES Université de Toulouse - INSA Toulouse - Institut National des Sciences Appliquées - Toulouse - CNRS - Centre National de la Recherche Scientifique)
    Abstract: In this paper we provide a valuation formula for different classes of actuarial and financial contracts which depend on a general loss process, by using the Malliavin calculus. In analogy with the celebrated Black-Scholes formula, we aim at expressing the expected cash flow in terms of a building block. The former is related to the loss process which is a cumulated sum indexed by a doubly stochastic Poisson process of claims allowed to be dependent on the intensity and the jump times of the counting process. For example, in the context of Stop-Loss contracts the building block is given by the distribution function of the terminal cumulated loss, taken at the Value at Risk when computing the Expected Shortfall risk measure.
    Date: 2017–07–13
  6. By: Wahyoe Soedarmono (Universitas Siswa Bangsa Internasional, Faculty of Business / Sampoerna School of Business); Djauhari Sitorus (The World Bank); Amine Tarazi (LAPE - Laboratoire d'Analyse et de Prospective Economique - UNILIM - Université de Limoges - IR SHS UNILIM - Institut Sciences de l'Homme et de la Société)
    Abstract: This paper investigates the interplay of abnormal loan growth, credit reporting system and systemic risk in banking. Based on a sample of publicly traded banks in Asia from 1998 to 2012, higher abnormal loan growth leads to higher systemic risk one year ahead. A closer investigation further suggests that better credit information coverage and private credit bureaus can stem the buildup of bank systemic risk one year ahead due to higher abnormal loan growth. Eventually, this paper offers some supports to strengthen macro-prudential regulation to limit abnormal loan growth. This paper also advocates the importance of strengthening credit information coverage and the role of private credit bureaus in Asian countries to mitigate the negative impact of abnormal loan growth on bank systemic stability.
    Keywords: credit reporting system,Abnormal loan growth,systemic risk,Asian banks
    Date: 2017–07–10
  7. By: Robert Deyoung (Kansas University, School of Business); Isabelle Distinguin (LAPE - Laboratoire d'Analyse et de Prospective Economique - UNILIM - Université de Limoges - IR SHS UNILIM - Institut Sciences de l'Homme et de la Société); Amine Tarazi (LAPE - Laboratoire d'Analyse et de Prospective Economique - UNILIM - Université de Limoges - IR SHS UNILIM - Institut Sciences de l'Homme et de la Société)
    Abstract: The Basel III Accord imposes minimum liquidity standards on bank balance sheets that are already constrained by minimum capital standards. It is not clear whether or how banks' behaviors will change in this new joint-constraint regime. To gain some insight, we study the balance sheet liquidity behavior of U.S. banking companies in response to negative equity capital shocks prior to the implementation of Basel III. Our 1998-2012 data indicate that banks treated regulatory capital and balance sheet liquidity (e.g., net stable funding ratios, core deposits-to-loans, liquid assets-to-assets) as substitutes rather than complements. This main finding is limited to so-called 'community banks' with assets less than $1 billion; equity capital and liquidity were neither substitutes nor complements at larger banks. In the course of rebuilding their capital ratios, shocked community banks substituted away from loans and loan commitments and reduced their dividend payouts, actions that resulted in greater balance sheet liquidity. Thus, in the state of nature that has traditionally most concerned bank regulators (i.e., stress to bank equity capital), community banks increase their liquidity buffers. Given that these lenders do not pose systemic risk, and that they have historically exceeded the Basel III liquidity minimums by wide margins, our findings suggest that imposing minimum liquidity thresholds on small banks will likely yield little prudential benefit.
    Keywords: Bank capital,bank liquidity,Basel III,lending,net stable funding ratio
    Date: 2017–07–10
  8. By: Yassine Bakkar (LAPE - Laboratoire d'Analyse et de Prospective Economique - UNILIM - Université de Limoges - IR SHS UNILIM - Institut Sciences de l'Homme et de la Société); Olivier De Jonghe (European Banking Center, Tilburg University and National Bank of Belgium. - Tilburg University and National Bank of Belgium); Amine Tarazi (LAPE - Laboratoire d'Analyse et de Prospective Economique - UNILIM - Université de Limoges - IR SHS UNILIM - Institut Sciences de l'Homme et de la Société)
    Abstract: Frictions prevent banks to immediately adjust their capital ratio towards their desired and/or imposed level. This paper analyzes (i) whether or not these frictions are larger for regulatory capital ratios vis-à-vis a plain leverage ratio; (ii) which adjustment channels banks use to adjust their capital ratio; and (iii) how the speed of adjustment and adjustment channels differ between large, systemic and complex banks versus small banks. Our results, obtained using a sample of listed banks across OECD countries for the 2001-2012 period, bear critical policy implications for the implementation of new (systemic risk-based) capital requirements and their impact on banks' balance sheets.
    Keywords: capital structure,speed of adjustment,systemic risk,systemic size,bank regulation
    Date: 2017–06–26
  9. By: Wujiang Lou
    Abstract: Haircutting non-cash collateral has become a key element of the post-crisis reform of the shadow banking system and OTC derivatives markets. This article develops a parametric haircut model by expanding haircut definitions beyond the traditional value-at-risk measure and employing a double-exponential jump-diffusion model for collateral market risk. Haircuts are solved to target credit risk measurements, including probability of default, expected loss or unexpected loss criteria. Comparing to data-driven approach typically run on proxy data series, the model enables sensitivity analysis and stress test, captures market liquidity risk, allows idiosyncratic risk adjustments, and incorporates relevant market information. Computational results for main equities, securitization, and corporate bonds show potential for uses in collateral agreements, e.g. CSAs, and for regulatory capital calculations.
    Date: 2017–08
  10. By: Adrian, Tobias; Boyarchenko, Nina
    Abstract: Bank liquidity shortages associated with the growth of wholesale-funded credit intermediation has motivated the implementation of liquidity regulations. We analyze a dynamic stochastic general equilibrium model in which liquidity and capital regulations interact with the supply of risk-free assets. In the model, the endogenously time varying tightness of liquidity and capital constraints generates intermediaries' leverage cycle, influencing the pricing of risk and the level of risk in the economy. Our analysis focuses on liquidity policies' implications for households' welfare. Within the context of our model, liquidity requirements are preferable to capital requirements, as tightening liquidity requirements lowers the likelihood of systemic distress without impairing consumption growth. In addition, we find that intermediate ranges of risk-free asset supply achieve higher welfare.
    Keywords: DSGE; Financial Intermediation; liquidity regulation; systemic risk
    JEL: E02 E32 G00 G28
    Date: 2017–08
  11. By: Taisuke Nakata
    Abstract: The target range for the federal funds rate has increased a few times since its liftoff from the effective lower bound (ELB) in December 2015 and currently stands at 1 to 1-1/4 percent. According to standard macroeconomic models, ELB risk--how likely it is for the policy rate to be constrained by the ELB in the near- and medium-term future--has important implications for interest rate policy. In this note, I construct measures of ELB risk by combining survey-based projections of the U.S. economy with stochastic simulations of the FRB/US model, a large-scale model of the US economy maintained and made public by Federal Reserve staff, and I examine how the ELB risk measures have evolved in the past and how they are likely to evolve in the future.
    Date: 2017–08–23
  12. By: Donal O'Neill (Department of Economics, Finance and Accounting, Maynooth University.)
    Abstract: In this paper, I consider how to isolate the contribution of competing risks to the overall difference in average durations between two groups. I propose a new decomposition, which is valid irrespective of the dependence structure across exit states or the shape of the underlying hazards. The new decomposition has an intuitive visual representation and is closely related to the Cumulative Incidence Function, previously used in competing risk analysis. I illustrate the decomposition by examining gender differences in the labour market response of 18 year-old jobseekers in Ireland to a 50% cut in unemployment benefits.
    Date: 2017
  13. By: Frantisek Cech; Jozef Barunik
    Abstract: This paper investigates how to measure common market risk factors using newly proposed Panel Quantile Regression Model for Returns. By exploring the fact that volatility crosses all quantiles of the return distribution and using penalized fixed effects estimator we are able to control for otherwise unobserved heterogeneity among financial assets. Direct benefits of the proposed approach are revealed in the portfolio Value-at-Risk forecasting application, where our modeling strategy performs significantly better than several benchmark models according to both statistical and economic comparison. In particular Panel Quantile Regression Model for Returns consistently outperforms all the competitors in the 5\% and 10\% quantiles. Sound statistical performance translates directly into economic gains which is demonstrated in the Global Minimum Value-at-Risk Portfolio and Markowitz-like comparison. Overall results of our research are important for correct identification of the sources of systemic risk, and are particularly attractive for high dimensional applications.
    Date: 2017–08
  14. By: J.A. Bikker; Tobias M. Vervliet
    Abstract: The aim of this paper is to investigate the impact of the unusually low interest rate environment on the soundness of the US banking sector in terms of profitability and risk-taking. Using both dynamic and static modeling approaches and various estimation techniques, we find that the low interest rate environment indeed impairs bank performance and compresses net interest margins. Nonetheless, banks have been able to maintain their overall level of profits, due to lower provisioning, which in turn may endanger financial stability. Banks did not compensate for their lower interest income by expanding operations to include trading activities with a higher risk exposure.
    Keywords: profitability, risk-taking, low interest rate environment, (dynamic) panel data models
    Date: 2017–07
  15. By: Davide Valenti; Giorgio Fazio; Bernardo Spagnolo
    Abstract: In financial markets, greater volatility is usually considered synonym of greater risk and instability. However, large market downturns and upturns are often preceded by long periods where price returns exhibit only small fluctuations. To investigate this surprising feature, here we propose using the mean first hitting time, i.e. the average time a stock return takes to undergo for the first time a large negative or positive variation, as an indicator of price stability, and relate this to a standard measure of volatility. In an empirical analysis of daily returns for $1071$ stocks traded in the New York Stock Exchange, we find that this measure of stability displays nonmonotonic behavior, with a maximum, as a function of volatility. Also, we show that the statistical properties of the empirical data can be reproduced by a nonlinear Heston model. This analysis implies that, contrary to conventional wisdom, not only high, but also low volatility values can be associated with higher instability in financial markets.
    Date: 2017–08
  16. By: Roxana Dumitrescu; Marie-Claire Quenez; Agn\`es Sulem
    Abstract: We study pricing and (super)hedging for American options in an imperfect market model with default, where the imperfections are taken into account via the nonlinearity of the wealth dynamics. The payoff is given by an RCLL adapted process $(\xi_t)$. We define the {\em seller's superhedging price} of the American option as the minimum of the initial capitals which allow the seller to build up a superhedging portfolio. We prove that this price coincides with the value function of an optimal stopping problem with nonlinear expectations induced by BSDEs with default jump, which corresponds to the solution of a reflected BSDE with lower barrier. Moreover, we show the existence of a superhedging portfolio strategy. We then consider the {\em buyer's superhedging price}, which is defined as the supremum of the initial wealths which allow the buyer to select an exercise time $\tau$ and a portfolio strategy $\varphi$ so that he/she is superhedged. Under the additional assumption of left upper semicontinuity along stopping times of $(\xi_t)$, we show the existence of a superhedge $(\tau, \varphi)$ for the buyer, as well as a characterization of the buyer's superhedging price via the solution of a nonlinear reflected BSDE with upper barrier.
    Date: 2017–08
  17. By: Marcelo Lima
    Abstract: This paper considers whether the answers to stated preference surveys (of the type used to monitise non-market goods) are affected by the survey's sponsoring institution. The sponsor is indicated to respondents by the logo used in the survey instrument, an online questionnaire. Survey repondents are randomly assigned to one of eight types of sponsor and whether stated willingness-to-pay for a product that reduces mortality risk is affected by the sponsor is observed. It is also considered whether sponsorship has an effect on measures of respondent engagement with the survey (survey completion rates, item response rates, time spend on the willingness to pay question and on the survey as a whole). The analysis finds that respondents that believe the survey to be sponsored by an environmental ministry or a health ministry are willing to pay significantly less for the product than those that believe that the survey is sponsored by other types of institution. There are also apparent trade-offs between the different repondent engagement measures considered.
    Date: 2017–08
  18. By: Khaled Guesmi (EconomiX - UPN - Université Paris Nanterre - CNRS - Centre National de la Recherche Scientifique); Sandrine Kablan (ERUDITE - Equipe de Recherche sur l’Utilisation des Données Individuelles en lien avec la Théorie Economique - UPEM - Université Paris-Est Marne-la-Vallée - UPEC UP12 - Université Paris-Est Créteil Val-de-Marne - Paris 12); Aymen Belgacem (LEO - Laboratoire d'économie d'Orleans - UO - Université d'Orléans - CNRS - Centre National de la Recherche Scientifique)
    Abstract: Using a sample of five-MENA emerging countries (Egypt, Tunisia, Morocco, Jordan, and Turkey) during the period 1996-2013, this study highlights the main factors that might influence regional integration of stock markets. We propose an advantageous econometric approach based on a conditional version of the International Capital Asset Pricing Model (ICAPM) to explore major sources of time-varying risks. We specifically apply the multivariate BEKK-GARCH process to simultaneously estimate the ICAPM for each country. The study puts in evidence that inflation, volatility of exchange rates, yield spread, current account deficit, dividend yield and economic growth are among the key determinants of regional integration in the MENA context whatever is the measure of exchange rate risk.
    Keywords: Multivariate GARCH,regional integration,ICAPM,MENA JEL Classification: F36,C32,G12
    Date: 2017–05–24
  19. By: Rıza Demirer (Department of Economics & Finance, Southern Illinois University Edwardsville, Edwardsville, USA); Rangan Gupta (Department of Economics, University of Pretoria, Pretoria, South Africa); Tahir Suleman (School of Economics and Finance, Victoria University of Wellington, New Zealand and School of Business, Wellington Institute of Technology, New Zealand); Mark E. Wohar (College of Business Administration, University of Nebraska at Omaha, Omaha, USA; School of Business and Economics, Loughborough University, Leicestershire, UK)
    Abstract: This paper provides a novel perspective to the predictive ability of rare disaster risks for West Texas Intermediate (WTI) oil market returns and volatility using a nonparametric quantile-based methodology over the monthly period of 1918:01-2013:12. We show that a nonlinear relationship and structural breaks exists between oil returns and various rare disaster risks; hence, linear Granger causality tests are misspecified and the linear model results of non-predictability are unreliable. However, the quantile-causality test shows that rare disaster-risks strongly affect both WTI returns and volatility, with stronger evidence of predictability observed at lower quantiles of the respective conditional distributions. Our results are robust to alternative specification of volatility (based on a GARCH model), and measure of rare disaster risks (based on the number of crises).
    Keywords: Oil Returns and Volatility, Rare Disasters, Nonparametric Quantile Causality
    JEL: C22 C58 G14 G15
    Date: 2017–08
  20. By: Giampiero M. Gallo (Dipartimento di Statistica, Informatica, Applicazioni "G. Parenti", Università di Firenze); Edoardo Otranto (Dipartimento di Economia and CRENoS, Università di Messina)
    Abstract: Volatility in financial markets is characterized by alternating persistent turmoil and quiet periods, but also by a slowly-varying average level. This slow moving component keeps open the question of whether some of its features are better represented as abrupt or smooth changes between local averages of volatility. We provide a new class of models with a set of parameters subject to abrupt changes in regime (Markov Switching -- MS) and another set subject to smooth transition (ST) changes. These models capture the possibility that regimes may overlap with one another ( fuzzy ). The empirical application is carried out on the volatility of four US indices. It shows that the flexibility of the new model allows for a better overall performance over either MS or ST, and provides a Local Average Volatility measure as a parametric estimation of the low frequency component.
    Keywords: Volatility modeling, Volatility forecasting, Multiplicative Error Model, Markov Switching, Smooth Transition, Common Trend
    JEL: C22 C32 C52 C58 C53
    Date: 2017–08

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