Asset correlations and bank capital adequacy

This paper addresses the estimation of confidence sets for asset correlations used in credit risk portfolio models. Research on the estimation of asset correlations using endogenous probabilities of default estimations has focused on the impact of concentration risk factors, such as firm size and industry. The empirical evidence from Italian small- and medium-size companies show that the assumptions underlying the Basel Committee regulatory capital risk weight function are not substantiated. The regulatory impact is that the capital adequacy is significantly compromised, driving an adverse selection, which favors the worst companies, and transferring the procyclical effects from firms to banks.     

IRB法下公司敞口组合的风险驱动因子计量研究

巴塞尔银行监管委员会针对防范信贷组合信用风险所需要的资本制定的内部评级法,通过风险驱动因子的变化来反映组合回报的变化,并根据风险权重函数,通过风险加权资产转化为与每一项信用风险敞口更准确匹配的资本要求.本文对违约概率、违约损失率、违约敞口、期限因素以及违约相关性等信贷组合信用风险的风险驱动因子的度量进行了综合研究.     

Der Einfluss von Cat Bonds-Emissionen auf das ökonomische Zielkapital von Schaden-/Unfallversicherungsunternehmen

One of the major problems in the market development of cat bonds is their impact on the economical capital requirement, while non-indemnity-triggers are used. In this article, an example portfolio is constructed which is heavily exposed to hurricane risks in Florida. A cat bond with a parametric trigger, a reinsurance without collateral and two other reference covers are used on this portfolio and their capital relief effect are calculated by means of monte carlo simulation. Amongst others, it shows that not only basis risk, but also default risk and cost disadvantage lead to the decline of a risk transfer instrument's capital relief effect. In the next step, the simulation is extended to the value based management with the capital requirement being a constraint and the maximization of the company's value being the objective function. In this context, the basis risk shows a much lower influence compared with the cost factors.     

Credit derivatives, capital requirements and opaque OTC markets

In this paper we study the optimal design of credit derivative contracts when banks have private information about their ability in the loan market and are subject to capital requirements. First, we prove that when banks are subject to a maximum loss capital requirement the optimal signaling contract is a binary credit default basket. Second, we show that if credit derivative markets are opaque then banks cannot commit to terminal-date risk exposure, and therefore the optimal signaling contract is more costly. The above results allow us to discuss the potential implications of different capital adequacy rules for the credit derivative markets.     

A guide to choosing absolute bank capital requirements

Resampling implementation of a stress-scenario approach to estimating portfolio default loss distributions is proposed as the basis for estimates of the appropriate absolute level of economic capital allocations for portfolio credit risk. Estimates are presented for stress scenarios of varying severity and implications of different time horizons are analyzed. Results for a numeraire portfolio are quite sensitive to such variations. Although the analysis is framed in terms of recent proposals to revise regulatory capital requirements for banks, the arguments and results are also relevant for bankers making capital structure decisions.     

The implications of the new capital adequacy rules for portfolio management of credit assets

Over the past several years, there has been an extensive discussion among practitioners and academics about whether and how a portfolio management approach could help banks to better manage risk capital and create shareholder value. In this article, the authors argue that there are four key drivers which require banks to move from a transactional to a more portfolio management like approach when managing credit assets. These are: structural changes in the credit markets, inefficiencies of risk transfer in lending markets, ballooning debt levels in the US, and the proposed changes for capital adequacy. The authors see the latter not as a one-time change in capital adequacy rules, but more as a first step towards full convergence between risk capital and regulatory capital for credit risk. These changes require banks to accelerate their efforts to build first class portfolio management skills and capabilities. Achieving best practice credit portfolio management is rewarded with attractive opportunities for shareholder value creation and enables bank to successfully compete going forward.     

Frailty Correlated Default

The probability of extreme default losses on portfolios of U.S. corporate debt is much greater than would be estimated under the standard assumption that default correlation arises only from exposure to observable risk factors. At the high confidence levels at which bank loan portfolio and collateralized debt obligation (CDO) default losses are typically measured for economic capital and rating purposes, conventionally based loss estimates are downward biased by a full order of magnitude on test portfolios. Our estimates are based on U.S. public nonfinancial firms between 1979 and 2004. We find strong evidence for the presence of common latent factors, even when controlling for observable factors that provide the most accurate available model of firm-by-firm default probabilities.     

Valuation of Portfolio Credit Derivatives with Default Intensities Using the Vasicek Model

We present a methodology for valuing portfolio credit derivatives under a reduced form model for which the default intensity processes of risk assets follow the one-factor Vasicek model. A closed-form solution of joint survival time distribution is obtained. The solution is applied to value credit derivatives of a credit default swap index and collateralized debt obligation. The limitation of methods using the Vasicek model is discussed. We propose that the method is valid and efficient for a portfolio with small-scale correlated risk assets, for which the acceptable size is much greater than for the traditional method. Numerical examples and parameter analysis are also presented.     

Bank capital buffer and portfolio risk: The influence of business cycle and revenue diversification

The relationship between macroeconomic developments and bank capital buffer and portfolio risk adjustments is relevant to assess the efficacy of newly created countercyclical buffer requirements. Using the U.S. bank holding company data over the period 1992:Q1–2011:Q3, we find a negative relationship between the business cycle and capital buffer. Our results offer some support for the Basel III agreements that countercyclical capital buffer in the banking sector is necessary to help the performance of the real economy during recessions. We find a robust evidence of inverse relationship between business cycle and bank default risk. Our analysis provides evidence of diversification benefits. The probability of insolvency risk decreases for diversified banks and banks with high revenue diversity achieve capital savings.     

资本充足率要求对商业银行业绩影响研究

以往考察资本充足率要求对商业银行业绩的影响,更多的是单纯考察其对商业银行盈利方面的影响,没有考虑到为了获得盈利而付出的代价——风险。因此我们采用因子分析法,将商业银行的盈利能力和风险状况作为商业银行业绩表现的两个方面进行综合考量,并在此基础上采用单因素和多因素回归分析法,考察资本充足率要求对商业银行业绩的绝对影响和相对影响。     

Risk Capital: Theory and Applications

After a brief review of the current theory and practice of risk capital by financial firms, the authors define the concept of risk capital and identify the costs and benefits of using more or less of it. Next, they present their procedure for allocating risk capital to assets and lines of business on the basis of marginal default values, and in a way designed to prevent risk shifting and internal arbitrage. Then, they show how allocations of risk capital are likely to be affected by, and in turn influence, a financial firm's decisions about both the scale and composition of its portfolio of businesses. Finally, the authors present a number of applications and consider their implications for maximizing the value of financial firms. In so doing, the authors also show how their method produces very different allocations of risk capital than those based on two measures that have long been widely used by financial firms: value at risk (VaR) and risk‐adjusted return on capital (RAROC). Moreover, the adjusted present value (APV) rule for evaluating investment opportunities is shown to be workable for nonfinancial as well as financial firms.     

An Assessment of Basel II Procyclicality in Mortgage Portfolios

In this paper we develop a probability of default (PD) model for mortgage loans, taking advantage of the Spanish Credit Register, a comprehensive database on loan characteristics and credit quality. From that model, we calculate different types of PDs: point in time, PIT, through the cycle, TTC, average across the cycle and acyclical. Then, we compare capital requirements coming from the different Basel II approaches. We show that minimum regulatory capital under Basel II can be very sensitive to the risk measurement methodology employed. Thus, the procyclicality of regulatory capital requirements under Basel II is an open question, depending on the way internal rating systems are implemented and their output is utilised. We focus on the mortgage portfolio since it is one of the most under researched areas regarding the impact of Basel II and because it is one of the most important of banks’ portfolios.     

Estimating the Cost of Equity for Property-Liability Insurance Companies

Due to the highly skewed and heavy‐tailed distributions associated with the insurance claims process, we evaluate the Rubinstein‐Leland (RL) model for its ability to improve the cost of equity estimates of insurance companies because of its distribution‐free feature. Our analyses show that there is as large as a 94‐basis‐point difference in the estimated cost of insurance equity between the RL model and the capital asset pricing model (CAPM) for the sample of property‐liability insurers with more severe departures from normality. In addition, consistent with our hypotheses, significant differences in the market risk estimates are found for insurers with return distributions that are asymmetrically distributed, and for small insurers. Third, we find significant performance improvements from using the RL model by showing smaller values of excess return of the expected return of the portfolio to the model return for a portfolio of insurers with returns that are more skewed and for a portfolio of small insurers. Finally, our panel data analysis shows the differences in the market risk estimates are significantly influenced by firm size, degree of leverage, and degree of asymmetry. The implication is that insurers should use the RL model rather than the CAPM to estimate its cost of capital if the insurer is small (assets size is less than $2,291 million), and/or its returns are not symmetrical (the value of skewness is greater than 0.509 or less than ?0.509).     

Capital Allocation and Risk Performance Measurement In a Financial Institution

This paper provides an analytical and practical framework, consistent with maximizing the wealth of existing shareholders, to address the following questions: What are the costs associated with economic capital? What is the tradeoff between the probability of default and the costs of economic capital? How do we take into account the time profile of economic capital when assessing the performance of a business? What is the appropriate measure of profitability, keeping the probability of default constant? It is shown that the capital budgeting decision depends not only on the covariance of the return of a project with the market portfolio, but also on the covariance with the bank's existing assets. This dependency arises from the simple fact that the economic capital is not additive.     

GOLBALIZATION, CORPORATE FINANCE, AND THE COST OF CAPITAL

International financial markets are progressively becoming one huge, integrated, global capital market—a development that is contributing to higher stock prices in developed as well as developing economies. For companies that are large and visible enough to attract global investors, having a global shareholder base means having a lower cost of capital and hence a greater equity value for two main reasons: First, because the risks of equity are shared among more investors with different portfolio exposures and hence a different “appetite” for bearing certain risks, equity market risk premiums should fall for all companies in countries with access to global markets. Although the largest reductions in cost of capital resulting from globalization will be experienced by companies in liberalizing economies that are gaining access to the global markets for the first time, risk premiums can also be expected to fall for firms in long-integrated markets as well. Second, when firms in countries with less-developed capital markets raise capital in the public markets of countries (like the U.S.) with highly developed markets, they get more than lower-cost capital; they also import at least aspects of the corporate governance systems that prevail in those markets. For companies accustomed to less-developed markets, raising capital overseas is likely to mean that more sophisticated investors, armed with more advanced technologies, will participate in monitoring their performance and management. And, in a virtuous cycle, more effective monitoring increases investor confidence in the future performance of those companies and so improves the terms on which they raise capital. Besides reducing market risk premiums and improving corporate governance, globalization also affects the systematic risk, or “beta,” of individual companies. In global markets, the beta of a firm's equity depends on how the stock contributes to the volatility not of the home market portfolio, but of the world market portfolio. For companies with access to global capital markets whose profitability is tied more closely to the local than to the global economy, use of the traditional Capital Asset Pricing Model (CAPM) will overstate the cost of capital because risks that are not diversifiable within a national economy can be diversified by holding a global portfolio. Thus, to reflect the new reality of a globally determined cost of capital, all companies with access to global markets should consider using a global CAPM that views a company as part of the global portfolio of stocks. In making this argument, the article reviews the growing body of academic studies that provide evidence of the predictive power of the global CAPM as well as the reduction in world risk premiums.     

Accounting-based downside risk,cost of capital,and the macroeconomy

We hypothesize that earnings downside risk, capturing the expectation for future downward operating performance, contains distinct information about firm risk and varies with cost of capital in the cross section of firms. Consistent with the validity of the earnings downside risk measure, we find that, relative to low earnings downside risk firms, high earnings downside risk firms experience more negative operating performance over the subsequent period, are more sensitive to downward macroeconomic states, and are more strongly linked to earnings attributes and other risk-related measures from prior research. In line with our prediction, we also find that earnings downside risk explains variation in firms’ cost of capital, and that this link between earnings downside risk and cost of capital is incremental to several earnings attributes, accounting and risk factor betas, return downside risk, default risk, earnings volatility, and firm fundamentals. Overall, this study contributes to accounting research by demonstrating the key valuation and risk assessment roles of earnings downside risk derived from firms’ financial statements, also shedding new light on the link between accounting and the macroeconomy.     

Portfolio optimization with a defaultable security

In this paper we derive a closed-form solution for a representative investor who optimally allocates her wealth among the following securities: a credit-risky asset, a default-free bank account, and a stock. Although the inclusion of a credit-related financial product in the portfolio selection is more realistic, no closed-form solutions to date are given in the literature when a recovery value is considered in the event of a default. While most authors have assumed some recovery scheme in their initial model set up, they do not address the portfolio problem with a recovery when a default actually occurs. Given the tractability of the recovery of market value, we solved the optimal portfolio problem for the representative investor whose utility function is a Constant Relative Risk Aversion utility function. We find that the investor will allocate larger fraction of wealth to the defaultable security as long as the default-event risk is priced. These results are very intuitive and reasonable since it indicates that if the default risk premium is not priced properly the investor purchases less defaultable securities.     

Equally weighted portfolios vs value weighted portfolios: Reasons for differing betas

We prove that constituent companies’ capital structure and tax shield cause the difference in systematic risk between an equally weighted portfolio and a value weighted portfolio in an efficient market where the CAPM holds. The difference in systematic risk has positive association with component companies’ default risk.     

The role of non-financial factors in internal credit ratings

Internal credit ratings are expected to gain in importance because of their potential use for determining regulatory capital adequacy and banks' increasing focus on the risk–return profile in commercial lending. Whereas the eligibility of financial factors as inputs for internal credit ratings is widely accepted, the role of non-financial factors remains ambiguous. Analyzing credit file data from four major German banks, we find evidence that the combined use of financial and non-financial factors leads to a more accurate prediction of future default events than the single use of each of these factors.     

Systemic Bank Risk in Brazil: A Comprehensive Simulation of Correlated Market, Credit, Sovereign and Inter-Bank Risks

In this study we present a comprehensive forward‐looking portfolio simulation methodology for assessing the correlated impacts of market risk, private sector and Sovereign credit risk, and inter‐bank default risk. In order to produce better integrated risk assessment for banks and systemic risk assessments for financial systems, we argue that reasonably detailed modeling of bank asset and liability structures, loan portfolio credit quality, and loan concentrations by sector, region and type, as well as a number of financial and economic environment risk drivers, is required. Sovereign and inter‐bank default risks are increasingly important in the current economic environment and their inclusion is an important model extension. This extended model is demonstrated through an application to both individual Brazilian banks (i.e., 28 of the largest banks) and groups of banks (i.e., the Brazilian banking system) as of December 2004. When omitting Sovereign risk, our analysis indicates that none of the banks face significant default risk over a 1‐year horizon. This low default risk stems primarily from the large amount of government securities held by Brazilian banks, but also reflects the banks' adequate capitalizations and extraordinarily high interest rate spreads. We note that none of the banks which we modeled failed during the very stressful 2007‐2008 period, consistent with our results. Our results also show that a commonly used approach of aggregating all banks into one single bank, for purposes of undertaking a systemic banking system risk assessment, results in a misestimate of both the probability and the cost of systemic banking system failures. Once Sovereign risk is considered and losses in the market value of government securities reach 10% (or higher), we find that several banks could fail during the same time period. These results demonstrate the well known risk of concentrated lending to a borrower, or type of borrower, which has a non‐zero probability of default (e.g., the Government of Brazil). Our analysis also indicates that, in the event of a Sovereign default, the Government of Brazil would face constrained debt management alternatives. To the best of our knowledge no one else has put forward a systematic methodology for assessing bank asset, liability, loan portfolio structure and correlated market and credit (private sector, Sovereign, and inter‐bank) default risk for banks and banking systems. We conclude that such forward‐looking risk assessment methodologies for assessing multiple correlated risks, combined with the targeted collection of specific types of data on bank portfolios, have the potential to better quantify overall bank and banking system risk levels, which can assist bank management, bank regulators, Sovereigns, rating agencies, and investors to make better informed and proactive risk management and investment decisions.