Measuring Integrated Market and Credit Risk in Bank Portfolios: An Application to a Set of Hypothetical Banks Operating in South Africa

The banking crises of the ‘90s emphasize the need to model the connections between financial environment volatility and the potential losses faced by financial institutions resulting from correlated market and credit risks. Due to the number of variables that must be modeled and the complexity of the relationships an analytical solution is not feasible. We present here a numerical solution based on a simulation model that explicitly links changes in the relevant variables that characterize the financial environment and the distribution of possible future bank capital ratios. This forward looking quantitative risk assessment methodology allows banks and regulators to identify potential risks before they materialize and make appropriate adjustments to bank portfolio credit qualities, sector and region concentrations, and capital ratios on a bank by bank basis. It also has the potential to be extended so as to assess the risks of correlated failures among a group of financial institutions (i.e., systemic risk analyses). This model was applied by the authors to the study of the risk profile of the largest South African Banks in the context of the Financial System Stability Assessment program undertaken by the IMF in 1999. In the current study, we apply the model to various hypothetical banks operating in the South African financial environment and assess the correlated market and credit risks associated with business lending, mortgage lending, asset and liability maturity matches, foreign lending and borrowing, and direct equity, real estate, and gold investments. It is shown to produce simulated financial environments (interest rates, exchange rates, equity indices, real estate price indices, commodity prices, and economic indicators) that match closely the assumed parameters, and generate reasonable credit transition probabilities and security prices. As expected, the credit quality and diversification characteristics of the loan portfolio, asset and liability maturity mismatches, and financial environment volatility, are shown to interact to determine bank risk levels. We find that the credit quality of a bank's loan portfolio is the most important risk factor. We also show the risk reduction benefits of diversifying the loan portfolio across various sectors and regions of the economy and the importance of accounting for volatility shocks that occur periodically in emerging economies. Banks with high credit risk and concentrated portfolios are shown to have a high risk of failure during periods of financial stress. Alternatively, banks with lower credit risk and broadly diversified loan portfolios across business and mortgage lending are unlikely to fail even during very volatile periods. Asset and liability maturity mismatches generally increase bank risk levels. However, because credit losses are positively correlated with interest rate increases, banks with high credit risk may reduce overall risk levels by holding liabilities with longer maturities than their assets. Risk assessment methodologies which measure market and credit risk separately do not capture these various interactions and thus misestimate overall risk levels.     

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.     

MATURITY AND REFUNDING EFFECTS ON TREASURY-BOND FUTURES PRICE VARIANCE

Both Samuelson's maturity hypothesis and the Anderson-Danthine state variable hypothesis are tested in this study of the variance of Treasury-bond futures prices. Both maturity and the quarterly refunding of Treasury debt have statistically and economically significant effects on futures price variance. The evidence for a monotonic maturity effect is highly statistically significant and robust to changes in model specification. The quarterly refunding is less statistically significant, and it is not clear whether the greatest effect is in the auction week or two weeks thereafter. Economically, these two predictable effects are of greater importance than a change in the discount rate.     

THE SURVIVAL ZONE FOR A BOND WITH BOTH CALL AND PUT OPTIONS EMBEDDED

We present a numerical method to price bonds that have multiple embedded options with an emphasis on the case with both long call and short put options. The valuation framework is a one-factor model for the term structure of interest rates, where the instantaneous interest rate is allowed to follow a fairly general stochastic process. The equilibrium interest rates that define the free boundaries for the embedded call and put options are given. We demonstrate the survival zone within which a bond with both long call and short put options remains afloat. We show that even moderate levels of transaction costs can have a significant effect on exercise of options.