Basel II: The Route Ahead or Cul‐de‐Sac?

Despite the best efforts of regulators, banking crises throughout the world have been on the rise and proved costly both in terms of the burden on taxpayers and the effect on output. The revised Basel Accord establishes new procedures for measuring the risk of bank loans and for calculating the capital that needs to be held against these loans. But if these new rules are undoubtedly an improvement on the existing ones, their continued focus on the risk of individual loans suggests that bank regulation is heading down a cul‐de‐sac. Ideally, one would like to be able to view individual loans as parts of portfolios, with better diversified portfolios assigned lower risks and capital requirements. But because of the difficulty of measuring the risk of loan portfolios (which stems from their complicated covariance structure), the author suggests that the regulators and their constituencies would be better served by requiring more realistic valuations of loan portfolios and other bank assets. In this sense, the design of effective capital adequacy rules involves a trade‐off between developing developing more precise measures of risk, on the one hand, and improving the frequency and accuracy of asset valuations, on the other. The author urges bank regulators to focus less on refinements of risk measurement and more on efforts to incorporate fair value accounting.     

A macro stress test model of credit risk for the Brazilian banking sector

This paper proposes a model to conduct macro stress test of credit risk for the banking sector based on scenario analysis. We employ an original bank-level data set that splits bank credit portfolios in 21 granular categories, covering household and corporate loans. The results corroborate the presence of a strong procyclical behavior of credit quality, and show a robust negative relationship between the logistic transformation of non-performing loans (NPLs) and GDP growth, with a lag response of up to three quarters. The results also indicate that the procyclical behavior of loan quality varies across credit types. This is novel in the literature and suggests that banks with larger exposures to highly procyclical credit types and economic sectors would tend to undergo sharper deterioration in the quality of their credit portfolios during an economic downturn. Lack of sufficient portfolio granularity in macro stress testing fails to capture these effects and thus introduces a source of bias that tends to underestimate the tail losses stemming from the riskier banks in a system.     

Ruin probabilities and optimal capital allocation for heterogeneous life annuity portfolios

A large part of the actuarial literature is devoted to the derivation of ruin probabilities in various non-life insurance risk models. On the contrary, very few papers deal with ruin probabilities for life insurance portfolios. The difficulties arise from the dependence and non-stationarity of the annual payments made by the insurance company. This paper shows that the ruin probability in case of life annuity portfolios can be computed from algorithms derived by De Pril (1989) and Dhaene & Vandebroek (1995). Approximations for ruin probabilities are discussed. The present article complements the works of Frostig et al. (2003) who considered whole life, endowment, and temporary assurances, and of Denuit & Frostig (2008) who considered homogeneous life annuities portfolios. Here, heterogeneous portfolios (with respect to age and/or face amounts) are studied. Particular attention is paid to the capital allocation problem. The total amount of reserve is shared among the risk classes in order to minimize the ruin probability. It is then fair to charge a higher margin to the risk classes requiring more capital.     

Default correlation: An empirical investigation of a subprime lender

In recent years, subprime lending has grown substantially as an important sector of the credit markets. This paper is concerned with the risk management of subprime loan portfolios and the importance of default correlation in measuring that risk. Using a large portfolio of residential subprime loans from an anonymous subprime lender, we show that default correlation is substantial for this lender. In particular, the significance of default correlation increases as the internal credit rating declines. Our results suggest that lenders and regulators would be well served investing in the understanding of default correlation in subprime portfolios.     

The sensitivity of bank stock returns to real estate

According to the Federal Reserve Board, banking firms have recently been shifting significantly larger portions of their loan portfolios into real estate. This increase in real estate lending has caused concern about the continuing economic health of banks on the part of state and federal regulators, since changes in real estate returns, evidenced by changes in property value, can potentially have a significant impact on bank default risk and profit-ability. However, concerned parties do not seem to have explicitly considered the relationship between mortgage default risk and the specific characteristics of real estate investments.This study examines the sensitivities of stock returns for different bank groups, based on the percentage of total loans in real estate and the percentage of loans in five different mortgage categories (construction and development loans, farmland loans, one- to four-family residential loans, multifamily residential loans, and nonresidential and nonfarm loans), to changes in real estate market returns. This is done by developing and using a three-index model.The results of this study indicate that bank stocks, overall, are very sensitive to changes in real estae returns. Banks, with a larger portion of their total loans invested in all types of real estate loans, except farmland loans, are most sensitive to changes in real estate returns.     

Assessing the risk-return trade-off in loan portfolios

This paper proposes a methodology to analyse the risk and return of large loan portfolios in a joint setting. I propose a tractable model to obtain the distribution of loan returns from observed interest rates and default frequencies. I follow a sectoral approach that captures the heterogeneous cyclical features of different kinds of loans and yields moments in closed form. I investigate the validity of mean–variance analysis with a value at risk constraint and study its relationship with utility maximisation. Finally, I study the efficiency of corporate and household loan portfolios in an empirical application to the Spanish banking system.     

Banks,bankruptcy, and public regulation

In a simple state-preference model with a complete capital market, some surprising implications of equilibrium in the banking industry are derived. For example, to limit a bank's probability of bankruptcy, it is sufficient for public regulators to control the composition and relative size of its portfolio or marketable securities. Generally, its loans need not be restricted. Also, under most publicly subsidized deposit insurance, bankers select very risky portfolios of bonds and loans with or without any risk adjustment in the insurance premium. In fact, with many types of subsidized insurance, public monitoring of bank loans is essential.     

Adverse selection in mortgage securitization

Using several large data sets of mortgage loans originated between 2004 and 2007, we find that in the prime mortgage market, banks generally sold low-default-risk loans into the secondary market while retaining higher-default-risk loans in their portfolios. In contrast, these lenders retained loans with lower prepayment risk relative to loans they sold. Securitization strategy of lenders changed dramatically in 2007 as the crisis set in with most unwilling to retain higher-default-risk loans in return for lower prepayment risk. Contrary to the prime market, the subprime market does not exhibit any clear pattern of adverse selection.     

The flight home effect: Evidence from the syndicated loan market during financial crises

This paper shows that the collapse of the global market for syndicated loans during financial crises can in part be explained by a flight home effect whereby lenders rebalance their loan portfolios in favor of domestic borrowers. The home bias of lenders' loan origination increases by approximately 20% if the bank's home country experiences a banking crisis. This flight home effect is distinct from flight to quality because borrowers of different quality are equally affected. The results indicate that the home bias in capital allocation tends to increase when adverse economic shocks reduce the wealth of international investors.     

THE ROBUSTNESS OF ABNORMAL RETURNS FROM THE EARNINGS YIELD CONTRARIAN INVESTMENT STRATEGY

We examine the sensitivity of the abnormal profitability of the earnings' yield (E/P)‐based contrarian investment strategy to the following two risk measurement issues: (a) return‐measurement interval over which systematic risk is estimated and (b) time variation in systematic risk. We conduct our analysis using the capital asset pricing model to parameterize risk. We find that the estimates of systematic risk of E/P‐ranked portfolios are not sensitive to the return‐measurement interval. Consequently the abnormal profits to the E/P‐based contrarian investment strategy observed in prior studies are not artifacts of the return‐measurement interval. Furthermore, although both the raw and abnormal returns to E/P‐ranked portfolios exhibit mean reversion, time variation in systematic risk ensuing from this mean‐reverting behavior does not substantially affect abnormal profits to E/P‐ranked portfolios. JEL classification: G11, G12, G14     

The common drivers of default risk

Using a unique data set on German banks’ loans to the German real economy, we investigate banks’ credit risk. This data set contains the volume of loans, and write-downs on loans, per bank and industry. Our empirical study for the period 2003–2011 yields the following results: (i) alongside the average nationwide credit loss rate, industry composition, regional factors, and the state of the global economy, the loans’ maturity structure is identified as an additional driver of the bank-wide loss rates in the credit portfolio. (ii) The nationwide loss rate has the largest impact, followed by the maturity structure and the industry composition. (iii) For nationwide banks, these common factors explain about 26% of the time variation in the loss rate of credit portfolios; for regional banks, this figure is less than 8%.     

The influence of sponsor,servicer, and underwriter characteristics on RMBS performance

This paper assesses how the default frequencies of RMBS loan portfolios vary depending on sponsor, servicer, and underwriter characteristics. We find that the larger and healthier the sponsor of the transaction, the lower the default frequency of the securitized loans. This finding is consistent with the hypothesis that banks with a longer market perspective are less willing to risk their good reputation for a gain in short-term profits. More surprisingly, we find that there is a negative relationship between the market share of the lead underwriter and default frequency. In contrast to reputational capital theory, it appears that investment banks with high market shares in the securitization business exploit their reputational capital.     

Competition,financial innovation and commercial bank loan portfolios

I examine how US commercial bank loan portfolios change in response to the rise of securitization markets and banking market deregulations over 1976–2003. Banks increasingly tilt their portfolios toward real-estate-backed loans. However, there are significant differences across banks. Larger banks and younger banks disproportionately shift their lending toward real-estate-backed loans, particularly commercial real-estate-backed loans, whereas smaller banks and older banks maintain greater shares of their loan portfolios in commercial and personal loans. When larger banks make more real-estate-backed loans, they charge lower interest rates, consistent with these banks lowering the costs of lending and expanding credit for borrowers. In contrast, smaller banks charge higher interest rates, consistent with these banks restricting lending to a select group of borrowers.     

Equity Home‐Bias: A Suboptimal Choice for UK investors?

In spite of the popularity of international portfolio diversification theory, extant empirical literature shows that investors prefer domestic assets and as a result, many studies argue that investors' portfolios are largely suboptimal. This paper examines whether British investors need to diversify their portfolios internationally to gain performance benefits from international markets or can they obtain these benefits by mimicking the portfolios with domestically traded assets. The results confirm that it is possible to mimic the performance of foreign equity with domestic equity. Indeed, the pay‐offs from homemade portfolios outperform those from international portfolios regardless of the periodic variation in the overall performance of the UK market vis‐à‐vis foreign markets. The superiority of homemade portfolio is more prominent in recent years and is enhanced by the increased internationalisation of developed capital markets. Therefore, investors' home bias is not suboptimal.     

资本计量方法改革、商业银行风险偏好与信贷配置

为提高银行业风险管理水平与信贷配置效率,监管部门于2014年开展了资本管理高级方法的试点工作。本文基于上市银行2010至2016年的微观数据,与银监会公布的行业信贷风险进行匹配,采用双重差分和三重差分法,实证分析前述改革如何影响试点银行的风险偏好和信贷调配。研究发现,在资本管理高级方法实施后:(1)试点银行显著降低了风险加权资产的规模;(2)试点银行风险偏好的变化存在非线性的特征,在调减高风险行业贷款的同时,并未显著增加最安全行业的贷款,而是增加了风险略高行业的贷款,体现出试点银行对风险与收益的权衡;(3)进一步将行业划分为“虚”与“实”,研究发现试点银行减少了房地产业(“虚”)、制造业(“实”)和建筑业(“实”)贷款,显著增加了金融业(“虚”)贷款。本文研究不仅丰富了资本监管方面的文献,也对金融支持供给侧结构性改革具有启示意义。     

The Optimal Mortgage Loan Portfolio in UK Regional Residential Real Estate

In this study, we propose a method based on large deviation theory (LDT), which minimises credit risk (expected loss). We demonstrate how mortgage loan portfolios can be optimised using geographical differences in the risk characteristics of mortgage loans in the UK. Our empirical results show that credit risk can be reduced by a third when the LDT method is used instead of the benchmark portfolios that we calculate with regional-gross-value-added weights and equal weights. More importantly, the difference in the expected loss between these portfolios increases further during bearish housing markets. To see that such numbers matter, in an extreme scenario, the UK mortgage lenders could lose more than 2% a year as the consequence of mortgage defaults, which is equivalent to an annual loss of approximately 20 billion pounds in the UK. Although this extreme state would not continue for a long time, it nevertheless represents a huge potential loss for mortgage lenders and investors.     

A Model of Shadow Banking

We present a model of shadow banking in which banks originate and trade loans, assemble them into diversified portfolios, and finance these portfolios externally with riskless debt. In this model: outside investor wealth drives the demand for riskless debt and indirectly for securitization, bank assets and leverage move together, banks become interconnected through markets, and banks increase their exposure to systematic risk as they reduce idiosyncratic risk through diversification. The shadow banking system is stable and welfare improving under rational expectations, but vulnerable to crises and liquidity dry‐ups when investors neglect tail risks.     

HOW MANY SMALL FIRMS ARE ENOUGH?

Individual investors are undiversified, holding on average less than four securities in their personal portfolios. The small firm literature focuses on CAPM (systematic risk, full diversification concept) premia, and the actual performance of small firm portfolios held by investors is overstated because of the presence of unsystematic risk. This paper illustrates the magnitudes of total risk for small and large firms, and the behavior of such measures as portfolio size is altered. Small firms contain more risk as shown by the finding that a diversified portfolio of small firms has greater variability than a single, typical large firm. While small firms outperform large firms, investors should be aware of the implications for small firm undiversified portfolios. Because small firms contain large amounts of unsystematic risk, diversification is important if investors are going to capture the small firm premia reported in the literature.     

Trade-off Model of Debt Maturity Structure

In this paper, we suggest the trade-off model to explain the choice of debt maturity. This model is based on balancing between risk and reward of using shorter-term loans. Shorter-term loans have cost advantage over, but incur higher refinancing and interest rate risk than longer-term loans. Using the Compustat data, we show that the principal components of financial attributes are financial flexibility and financial strength. Therefore, only firms with greater financial flexibility and financial strength can use proportionately more short-term loans. We also document that financially strong firms take advantage of lower interest rates of short-term debt. They use proportionately more short-term loans when the term premium is high. The results of our study also provide evidence supporting the agency cost hypothesis, which is strongly supported by current literature.     

Household Income, Termination Risk and Mortgage Pricing

The premium embedded in home mortgage loans to compensate investors for their exposure to prepayment risk is a significant component of the cost of home mortgage lending. Moreover, there is some reason to believe that prepayment risk may be lower for loans to lower-income housing borrowers, especially those that are first-time home owners. If so, investor recognition of this advantage should facilitate greater willingness to acquire portfolios of lower-income housing loans, and encourage more competitive pricing in this segment of the market. This study investigates the possibility of differential mortgage prepayment behavior between lower-income home owners and non-low income home owners. The investigation relies on samples of the American Housing Survey spanning ten years of experience from 1985 to 1995. We find no significant difference between the termination or refinancing behavior of non-low income and low-income households. This result is robust to a number of alternative specifications such as restricting the low-income test group to non-moving households and to first-time owners. The same conclusions are derived from both aggregate prepayment rates and from analysis of individual household prepayment behavior.