Beyond Basel-2 simplified standardized approach: Credit risk valuation of short-term loan commitments

As alternative to Basel-2 coefficients, this research proposes markup-based risk weights for short-term credit commitments. To do this, Basel-2 credit-conversion and principal-risk factors are replaced by a duration-dependent takedown proportion and a commitment put option that accounts for the nonnormal features of the underlying credit-line marked-to-market value. Put value and takedown proportion are then combined to compute the ‘fair’ capital charge corresponding to the commitment ‘true’ credit risk. As benchmark, the option-based procedure is used next to assess the accuracy of Basel-2 accounting-based capital charges, impose some quasi-market discipline and align regulatory and economic capital requirements. The final step generalises the fair procedure to a new risk-weighting system, which also accounts for the borrowers' risk ratings of public credit agencies.     

Marking-to-model credit and operational risks of loan commitments: A Basel-2 advanced internal ratings-based approach

Within a marking-to-model framework, this research computes the bank's capital charge for credit and operational risks of loan commitments at Basel-2 fixed audit date. This is done in three steps. The first one prices commitment credit risk as a Gram-Charlier put value and determines the commitment forward-funding proportion. In the second one, put value and funding proportion are combined to compute Basel-2 ‘fair’ capital charge for credit and operational risks. By producing a moderate total capital charge, marking-to-model offers substantial capital relief with respect to the corresponding charge computed with Basel-2 simplified approach. Both charges are however larger than the corresponding nil charge arrived at in Basel-1. In the third step, marking-to-model reveals its flexibility by showing how banks can determine the cost of their exposure to borrowers' credit-rating downgrades and how they can also hedge any exposure to commitment default risk.     

Valuation of insurers’ contingent capital with counterparty risk and price endogeneity

This study develops a structural framework to value insurers’ contingent capital with counterparty risk (CR) and overcomes the problem of price endogeneity (PE) in the valuation model. Our results on the focal contingent capital instrument – catastrophe equity put option (CatEPut) – indicate that prices can be significantly overestimated without considering CR and be significantly underestimated without considering PE. This study also examines how CatEPuts affect the buyer’s probability of default (PD). Our results show that buying a CatEPut lowers the PD for high-risk insurers, but not necessarily so for low-risk insurers; however, without taking CR and PE into account, one may significantly overestimate the credit enhancement provided by the CatEPuts.     

The price-setting behavior of banks: An analysis of open-end leverage certificates on the German market

This paper presents the first analysis of open-end leverage certificates on the German market. The major innovations of these certificates are twofold. First, issuers announce a price-setting formula according to which they are willing to buy and sell the certificates over time. Second, the product’s lifetime is potentially endless. Our main findings are that the price-setting formula is (i) designed to strongly favor the issuer and (ii) is consistent with the main outcome of the ‘life cycle hypothesis’ for structured financial products [Stoimenov, P.A., Wilkens, S., 2005. Are structured products ‘fairly’ priced? An analysis of the German market for equity-linked instruments. Journal of Banking and Finance 29, 2971–2993]. (iii) This holds for different product features and also in the presence of issuers’ credit risk and jump risk in the underlying.     

Why ‘Basel II’ may need a leverage ratio restriction

We analyze regulatory capital requirements where the amount of required capital depends on the level of risk reported by the banks. It is shown that if the supervisors have a limited ability to identify or to sanction dishonest banks, an additional, risk-independent leverage ratio restriction may be necessary to induce truthful risk reporting. The leverage ratio helps to offset the banks’ potential capital savings of understating their risks by (i) reducing banks’ put option value of limited liability ex ante, and by (ii) increasing the banks’ net worth, which in turn enhances the supervisors’ ability to sanction banks ex post.     

Sovereign ceilings “lite”? The impact of sovereign ratings on corporate ratings

Although credit rating agencies have gradually moved away from a policy of never rating a corporation above the sovereign (the ‘sovereign ceiling’), it appears that sovereign credit ratings remain a significant determinant of corporate credit ratings. We examine this link using data for advanced and emerging economies over the period of 1995–2009. Our main result is that a sovereign ceiling continues to affect the rating of corporations. The results also suggest that the influence of a sovereign ceiling on corporate ratings remains particularly significant in countries where capital account restrictions are still in place and with high political risk.     

From new deal institutions to capital markets: Commercial consumer risk scores and the making of subprime mortgage finance

The investment fueled US mortgage market has traditionally been sustained by New Deal institutions called government sponsored enterprises (GSEs). Known as Freddie Mac and Fannie Mae, the GSEs once dominated mortgage backed securities underwriting. The recent subprime mortgage crisis has drawn attention to the fact that during the real estate boom, these agencies were temporarily overtaken by risk tolerant channels of lending, securitization, and investment, driven by investment banks and private capital players. This research traces the movement of a specific brand of commercial consumer credit analytics into mortgage underwriting. It demonstrates that what might look like the spontaneous rise (and fall) of a ‘free’ market divested of direct government intervention has been thoroughly embedded in the concerted movement of calculative risk management technologies. The transformations began with a sequence of GSE decisions taken in the mid-1990’s to implement a consumer risk score called a FICO^® into automated underwriting systems. Having been endorsed by the GSEs, this scoring tool was gradually hardwired throughout the industry to become a distributed and collective ‘market device’. As the paper will show, once modified by specific GSE interpretations the calculative properties generated by these credit bureau scores reconfigured mortgage finance into two parts: the conventional, risk-adverse, GSE conforming ‘prime’ and an infrastructurally distinct, risk-avaricious, investment grade ‘subprime’.     

Stock return volatility,operating performance and stock returns: International evidence on drivers of the ‘low volatility’ anomaly

This study highlights the link between stock return volatility, operating performance, and stock returns. Prior studies suggest that there is a ‘low volatility’ anomaly, where firms with a low stock return volatility out-perform firms with a high stock return volatility. This paper confirms that low volatility stocks earn higher returns than high volatility stocks in emerging markets and developed markets outside of North America. We also show that low volatility stocks have higher operating returns and this might explain why low volatility stocks earn higher stock returns. These results provide a partial explanation for the ‘low volatility effect’ that is independent from the existence of market anomalies or per se inefficiencies that might otherwise drive a low volatility effect. We emphasize the importance of controlling for stock return volatility when analyzing operating performance and stock performance.     

Optimal portfolios with minimum capital requirements

We propose a novel approach to active risk management based on the recent Basel II regulations to obtain optimal portfolios with minimum capital requirements. In order to avoid regulatory penalties due to an excessive number of Value-at-Risk (VaR) violations, capital requirements are minimized subject to a given number of violations over the previous trading year. Capital requirements are based on the recent Basel II amendments to account for the ‘stressed’ VaR, that is, the downside risk of the portfolio under extreme adverse market conditions. An empirical application for two portfolios involving different types of assets and alternative stress scenarios demonstrates that the proposed approach delivers an improved balance between capital requirement levels and the number of VaR exceedances. Furthermore, the risk-adjusted performance of the proposed approach is superior to that of minimum-VaR and minimum-stressed VaR portfolios.     

‘Exploratory landscape scenarios’ in the formulation of ‘landscape quality objectives’

The European Landscape Convention (ELC) calls for the definition of ‘landscape quality objectives’ (LQO) as “the formulation by the competent public authorities of the aspirations of the public with regard to the landscape features of their surroundings”. However, it is not yet defined how the integration of the visions of the public should be carried out. Notably in regions with poor participatory culture and in rural landscapes abandoned by people and consequently by their activities, dealing with the future does not seem a straightforward task. In these marginal rural landscapes the role of agriculture is being altered under the influence of the new rationale of the Common Agriculture Policy, so it may have to assume different functions in the future. Thus, this paper aims at showing how the development of ‘exploratory landscape scenarios’ can be a useful tool, firstly to find plausible landscape futures, and secondly to trigger discussions with the public regarding their aspirations for their landscape. The development procedure for ‘exploratory landscape scenarios’ builds on the ‘intuitive logics’ approach that focuses on the production of a variety of scenarios as starting point for discussion about the future rather than on finding an optimal one, which can limit the options unnecessarily from the beginning. The methodological approach is illustrated at a local scale by using the case study of Mértola in southeast Portugal. The results of the scenario exercise point out the adequateness of the methodology in the development of futures that are perceived as plausible by local stakeholders and, thereby, able to bring out their desires and threats towards the future of their landscape.     

Endogenizing exogenous default barrier models: The MM algorithm

In this paper, we propose a Maximization–Maximization (MM) algorithm for the assessment of hidden parameters in structural credit risk models. Step M1 updates the value, volatility, and expected return on the firm’s assets by maximizing the log-likelihood function for the time series of equity prices; Step M2 updates the default barrier by maximizing the equity holders’ participation in the firm’s asset value. The main contribution of the method lies in the M2 step, which allows for ‘endogenizing’ the default barrier in light of actual data on equity prices. Using a large international sample of companies, we demonstrate that theoretical credit spreads based on the MM algorithm offer the lowest CDS pricing errors when compared to other, traditional default barrier specifications: smooth-pasting condition value, maximum likelihood estimate, KMV’s default point, and nominal debt.     

Here be dragons… exploring the ‘unknown unknowns’

Since ancient times, the phrase ‘Here be Dragons’ has been used to signify dangerous and unexplored territories. While wayfarers of the past realised that lack of knowledge necessitated increased vigilance and caution, today's ‘Here be Dragons’ generally remain hidden and unwanted. Human psychology, institutional frameworks and scientific convention have removed these unrecognised sources of ignorance from the mental maps of modern society. This omission is critical in today's interconnected, interdependent world. It is now time to counter current myopia by using the new digital tools available to draw on wider societal framing in conjunction with scenarios methodologies. This process could provide the meta risk analysis suitable to enable the ‘Here be Dragons’ to be identified, monitored and tackled, thereby ensuring that decision-makers and ultimately society become more aware of intractable uncertainty and adaptive in the face of inevitable change.     

Future Search as ‘real-time’ action research

This paper explores essential links between the brief planning meeting that we call ‘future search’ and the action research tradition of pioneer social psychologist Kurt Lewin. The two practices, based on common values, employ different procedures. Unlike action research, future search involves stakeholders in collecting and organizing their own data, and deciding what to do, all in a single meeting. Unlike scenario planning, future search leads people to create the future they most desire without assessing the probability of attaining it, We work on the assumption that people who put their energy into what they want are more likely to have it. We think of future search as an intersection of three levels of social change practice: (1) a meeting design based on four key principles to be described; (2) a theory and philosophy of facilitating that might be characterized as ‘doing less so that participants can do more;’ (3) a whole system change strategy requiring no special training, systems theory or vocabulary. This article highlights the first level, showing how principles grounded in the Lewinian tradition are translated into a meeting design that stimulates ongoing cooperative action.     

The science of ‘what-if?’

An appropriate response to the new challenges to science will require more than new explicit goals and social organisation. New leading questions will be appropriate. The traditional questions of ‘what/how?’ for research and ‘how/why?’ for the design fields, will be supplemented by ‘what-if?’. This previously had its place in exploratory phases of all research; now it will become an essential component of ‘post-normal’ science. Its form precludes the dogmatic and exclusive styles which have hitherto been dominant in science as applied to policy problems; and it lends itself to open enquiry and public participation.     

Evidence on the insurance effect of bankruptcy exemptions

Defaulting on one’s debts when experiencing an adverse event can help insure households against unexpected income risks. But the effect of allowing default on debt levels is ambiguous, not least because lenders may restrict access to credit. Hence the optimal punishment for bankruptcy is unclear. The US states allows householders to keep a variety of assets when filing for bankruptcy – the ‘bankruptcy exemptions’ – and these exemptions change substantially between states and over time. By exploiting these differences this study shows that raising the exemptions (i) marginally decreases the level of unsecured debt that household’s hold; (ii) makes consumption smoother. Thus, despite the effect on debt levels, the generous provisions to debtors in arrears may be helping US households to insure themselves against income risk.     

IPOs,trade sales and liquidations: Modelling venture capital exits using survival analysis

This paper examines the dynamics of exit options for US venture capital funds. Using a sample of more than 20,000 investment rounds, we analyze the time to ‘IPO’, ‘trade sale’ and ‘liquidation’ for 6000 VC-backed firms. We model these exit times using competing risks models, which allow for a joint analysis of exit type and exit timing. The hazard rate for IPOs are clearly non-monotonic with respect to time. As time flows, VC-backed firms first exhibit an increased likelihood of exiting to an IPO. However, after having reached a plateau, non-exited investments have fewer possibilities of IPO exits as time increases. This sharply contrasts with trade sale exits, where the hazard rate is less time-varying. We further provide evidence on the impact of economic factors such as syndicate size and composition, geographical location and VC value adding, on exit outcomes.     

A productivity analysis of Central and Eastern European banking taking into account risk decomposition and environmental variables

This paper develops a Luenberger productivity index that is applied to a technology where desirable and undesirable outputs are jointly produced and are possibly negative. The components of this Luenberger productivity index - the efficiency change and the components of the technological shift - are then decomposed into factors determined by the technology, adjusted and then for ‘risk and environment’, ‘risk management’ and ‘environmental effects’. The method is applied to Central and Eastern European banks operating during 1998-2003 utilising three alternative input/output methodologies (intermediation, production and profit/revenue). Additionally, the comparative analysis of the sensitivity of the productivity indices in the choice of the methodologies is undertaken using statistical and kernel density tests. It is found that the main driver of productivity change in Central and Eastern European banks is technological improvement. That is, in the beginning of the analysed period, the results hinged on the banks ability to capitalise on advanced technology and successfully take into account ‘risk and environmental’ factors. Whereas, in later periods, one of the most important factors of technological improvement/decline was ‘risk management’. Finally, the tests employed confirm previous findings, such as Pasiouras (2008)in this journal, that different input/output methodologies produce statistically different productivity results. Finally, we find that external factors, such as ‘risk in the economy’ and banking production, and a ‘corruption perception’ affect the productivity of banks.     

The ‘laissez faire’ bias of managed floating

The government of a small open economy trying to manage its exchange rate faces a ‘time consistency’ problem. If markets expect implementation of the optimal linear intervention rule, the government will be tempted to ‘defect’: knowing this, markets will expect less activism; and, in the discretionary equilibrium, this is what they get. How far this credibility problem can shift discretionary policy towards a free float is shown in two popular models of floating rates. One way of offsetting the ‘laissez faire’ bias of discretionary policy is to appoint a relatively ‘conservative’ central banker: but, as the time period of policy action and precommitment shrinks towards zero, the required conservative bias is found to go towards infinity. Other institutional features — such as central bank reputation, contracts and intermediate targets — may be crucial for successful exchange rate management.     

What's in a name: Reflections on Ziauddin Sardar's ‘the namesake’

This paper argues that the semantic difficulties surrounding the term ‘futures’ and its many variants have significantly impacted this field's legitimacy in public policy circles, as viewed from the experiences of this author. Lacking legitimacy, it has been difficult to build the number of academic programs in the United States needed to improve the field's legitimacy, branding, and quality. In addition to issue of semantics, the field needs to improve its central messages while maintaining its core strengths; diversity of thought and commitment to future generations.