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

credit and market risks measurement in carbon financing for chinese banks abstract this paper concerns the risk analysis of six chinese banks which are involved in carbon financing factor copula is introduced to simulate the corresponding carbon finance credit risk and market risk by latent variables in an indirect method in short the four common factors in carbon financing exchange rates interest rates cer price and brent oil prices are analyzed and explored in factor copula approach that incorporates kmv garch models in two steps the kmv and garch models are used to generate data that reflects the overall credit and market risk associated with each bank both normal copula and t copula functions are used to simulate the parameter estimations for comparison in a new way the value at risk for each of the six banks is calculated through a monte carlo simulation and compared additionally we calculate shock estimates for each factor to explore the changes in both credit risk and market risk given economic shocks also make a hypothetical analysis of the impact of the financial crisis on common factors overall our findings reveal that exchange rates and oil prices are the key factors to consider in carbon financing ping an bank is facing the most risk of all the banks in the sample while the industrial and commercial bank of china is carrying the least risk the results of this analysis gave provide some insight into domestic carbon trading and carbon markets connectivity

economic and regulatory capital allocation for revolving retail exposures abstract we present two internal capital allocation models and compare the capital ratios they generate with those prescribed by the latest revision of basel s new capital accord proposal for advanced retail portfolios which allows for explicit future margin income recognition given a test portfolio of credit card exposures that we assemble we find that basel s ratios are closer to those generated by our models for low credit risk segments we attribute the discrepancies to the different ways basel and our models account for future margin income to basel s assumptions about asset correlations and to one model taking macroeconomic conditions into account

the asymmetric behavior and procyclical impact of asset correlations abstract this paper examines the behavior of asset correlations with the market returns in the asymptotic single risk factor asrf approach of the basel ii accord on regulatory capital requirement over a sample period from 1988 to 2007 we find that asset correlations are positively related to firm size but negatively related to firm default probability asset correlations are also industry specific as firms in media transportation pharmaceutical and semiconductor industries exhibit higher asset correlations than those in retail and consumer staples most importantly asset correlations are asymmetric and have a procyclical impact on the real economy after controlling for these effects they tend to rise during economic downturns but decline during economic upturns the average magnitude of the rise is larger than that of the decline these findings suggest that asset correlations may be underestimated during economic downturns and may provide policy implications for the capital requirement framework

an approximation method for analysis and valuation of credit correlation derivatives abstract this paper presents a model for approximating the value of a basket of default correlated assets and analyzes subordinate tranches in securitized debt obligations the model is calibrated to an intensity based simulation of correlated defaults and represents an alternative computation method to full monte carlo simulation timing of individual obligor defaults are driven by intensity processes and collateral value is modeled with a jump diffusion process where the number of jumps corresponds to the total number of defaults in the asset pool this approach allows decomposition of subordinate obligations in terms of a collection of simpler securities and yields useful risk management information

credit risk drivers evaluating the contribution of firm level information and of macroeconomic dynamics abstract understanding if credit risk is driven mostly by idiosyncratic firm characteristics or by systematic factors is an important issue for the assessment of financial stability by exploring the links between credit risk and macroeconomic developments we observe that in periods of economic growth there may be some tendency towards excessive risk taking using an extensive dataset with detailed information for more than 30 000 firms we show that default probabilities are influenced by several firm specific characteristics when time effect controls or macroeconomic variables are also taken into account the results improve substantially hence though the firms financial situation has a central role in explaining default probabilities macroeconomic conditions are also very important when assessing default probabilities over time

regulatory implications of credit risk modelling abstract this introduction places in context the papers on credit risk modelling contained in the special issue we explain why credit risk modelling has become such a focus of interest for practitioners and financial supervisors even though as we explain the current modelling technologies have significant weaknesses they offer the possibility of major changes in the ways banks are managed and regulated the main impediment to greater use of these models especially by regulators is the difficulty involved in back testing the risk measures they produce we suggest some thoughts on how back testing and other types of model assessment might be performed

a comparative analysis of current credit risk models the new bis 1998 capital requirements for market risks allows banks to use internal models to assess regulatory capital related to both general market risk and credit risk for their trading book this paper reviews the current proposed industry sponsored credit value at risk methodologies first the credit migration approach as proposed by jp morgan with creditmetrics is based on the probability of moving from one credit quality to another including default within a given time horizon second the option pricing or structural approach as initiated by kmv and which is based on the asset value model originally proposed by merton merton r 1974 journal of finance 28 449 470 in this model the default process is endogenous and relates to the capital structure of the firm default occurs when the value of the firm s assets falls below some critical level third the actuarial approach as proposed by credit suisse financial products csfp with creditrisk and which only focuses on default default for individual bonds or loans is assumed to follow an exogenous poisson process finally mckinsey proposes creditportfolioview which is a discrete time multi period model where default probabilities are conditional on the macro variables like unemployment the level of interest rates the growth rate in the economy which to a large extent drive the credit cycle in the economy 2000 elsevier science b v all rights reserved

explaining regional autonomy differences in decentralized countries why do groups want to secede and where is demand for self determination most likely to arise we argue self determination demand is moderated by the projected economic costs of policy autonomy the trade off between income and sovereignty implies that other things being equal richer regions are more likely to demand more autonomy this trade off suggests that relative regional income is a key predictor of autonomy demands we show evidence of this using new data collected at the level of second tier administrative sub divisions in 48 decentralized countries consistent with a demand and supply model of self determination we find that levels of policy autonomy are positively correlated with relative regional income regional population share natural resource endowment and regional inter personal inequality ethnically distinct regions have lower sovereignty which could explain higher levels of conflict in these regions but this association is conditional on controlling for the interactive effects be

estimating systemic risk in the international financial system this paper develops three distinct methods to quantify the risk of a systemic failure in the global banking system we examine a sample of 334 banks representing 80 of global bank equity in 28 countries around five global financial crises our results suggest statistically significant but economically small increases in systemic risk although policy responses are endogenous the low estimated probabilities suggest that the distress of central bankers regulators and politicians about the events we study could be overstated and that current policy responses to financial crises could be adequate to handle major macroeconomic events

the pricing of deposit insurance in the presence of systematic risk based on the merton 1977 put option framework we develop a deposit insurance pricing model that incorporates asset correlations a measurement for the systematic risk of a bank to account for the risk of joint bank failures estimates from our model suggest that actuarially fair risk based deposit insurance that considers only individual bank failure risk is underpriced leaving insurance providers exposed to net losses our estimates also capture the size premium where big banks are priced with higher deposit insurance than small banks this result is particularly relevant to the current regulatory concerns on big banks that are too big to fail above all our approach provides a unifying framework for integrating risk based deposit insurance with risk based basel capital requirements

loss given default of residential mortgages in a low ltv regime role of foreclosure auction process and housing market cycles abstract using loan level foreclosure auction data we study the loss given default lgd of defaulted residential mortgages originated in korea a low ltv regime we find that senior mortgages generate very low loss rates 5 10 while losses of subordinated claims are in 30 50 range we document the effects of housing market cycles on loss severity by showing that collateral characteristics that are overvalued during the boom increase loss severity during the market downturn we also investigate how a broad set of time of origination and post origination information on loan collateral and borrower characteristics and foreclosure auction process influence the lgd of residential mortgages

cyclical correlations credit contagion and portfolio losses abstract we model aggregate credit losses on large portfolios of financial positions contracted with firms subject to both cyclical default correlation and direct default contagion processes cyclical correlation is due to the dependence of firms on common economic factors contagion is associated with the local interaction of firms with their business partners we provide an explicit normal approximation of the distribution of portfolio losses we quantify the relation between the variability of global economic fundamentals strength of local firm interaction and the fluctuation of losses we find that cyclical oscillations in fundamentals dominate average losses while local interaction causes additional fluctuations of losses around their average the strength of the contagion induced loss variability depends on the complexity of the business partner network

on the use of portfolio risk models and capital requirements in emerging markets the case of argentina a portfolio based model credit risk of credit suisse first boston and recent central bank of argentina credit bureau data are used to estimate whether current capital and provisioning regulations match actual risks arguing that provisions should cover expected losses and that capital requirements should cover potential losses beyond expected losses subject to some statistical level of tolerance the article assesses how well actual capital and provisioning requirements match the estimated requirements given by the model actual provisioning requirements were found to be close to implied levels of expected losses the estimate of potential losses was found to be highly sensitive to the assumptions of the model especially the parameter relating the volatility of a loan s rate of default to its mean value this volatility parameter cannot be estimated accurately with the credit bureau data because of the short time span covered so proxy data were used to estimate it and two values around that estimate were tried the difficulty of estimating this critical parameter implies that the results should only be regarded as suggestive moreover the methodology only does not seek to estimate credit risk and not interest rate risk or exchange rate risk nor does it fully take into account the indirect effects of interest rates and exchange rates on credit risk as recent events in argentina have demonstrated estimating credit risk along these lines should be thought of as just one tool in attempting to assess the appropriate level of bank provisions and capital

evaluating systemic risk using bank default probabilities in financial networks in this paper we propose a novel methodology to measure systemic risk in networks composed of financial institutions our procedure combines the impact effects obtained from stress measures that rely on feedback centrality properties with the default probabilities of institutions we also present new heuristics for designing feasible and relevant stress testing scenarios that can subside regulators in financial system surveillance tasks we develop a methodology to extract banking communities and show that these communities have a relevant effect on systemic risk we find that these communities are mostly composed of non large banks suggesting that regulators should also broaden their surveillance efforts to these banking communities other than to the usual sifis and large banks finally our results provide insights and guidelines for policymakers

integrated models of capital adequacy why banks are undercapitalised with the majority of large uk and many us banks collapsing or being forced to raise capital over the 2007 9 period blaming bankers may be satisfying but is patently insucient basel ii and federal oversight frameworks also deserve criticism we propose that the current methodological void at the heart of basel ii pillar 2 is filled with the recommendation that banks develop fully integrated models for economic capital that relate asset values to fundamental drivers of risk in the economy to capture systematic eects and inter asset dependencies in a way that crude correlation assumptions do not we implement a fully integrated risk analysis based on the balance sheet of a representative eurobank using an economic scenario generation model calibrated to conditions at the end of 2007 our results suggest that the more modular correlation based approaches to economic capital that currently dominate practice will have led to an undercapitalisation of banks a

selecting an optimal portfolio of consumer loans by applying the state preference approach abstract internal models like creditmetrics and kmv implemented by banks to manage credit risk and assess regulatory capital are significant examples of how practitioners apply modern portfolio theory mpt to the management of bank loan portfolios from a theoretical perspective there are several reasons suggesting to be careful in extending mpt to the case of bank loan portfolios selection in order to avoid misleading results specifically loans log returns are non normally distributed random variables furthermore decision makers not necessarily perform a quadratic utility function because both of those reasons the traditional mean variance approach is inadequate in building up optimal loan portfolios such a conclusion is even more relevant if specific categories of loans are considered in our paper we deal with the problem of selecting optimal portfolios of consumer loans by developing a state preference model it allows us not to explicitly consider the distributional properties of loans log returns the model is a static one having the objective to select the loan portfolio maximizing the expected utility of wealth allocated by the bank managers subject to a number of constraints accounting for fundamental strategic choices implemented by the bank managers our results show that flexibility is the main characteristic of our model in fact adding constraints gives new optimal portfolios without reducing the expected utility of the decision maker we will explain that such a result does not depend on constraints misspecification but on the risk structure implied in the state preference approach

on the use of portfolio risk models and capital requirements in emerging markets a portfolio based model creditrisk of credit suisse first boston and recent central bank of argentina credit bureau data are used to estimate whether current capital and provisioning regulations match actual risks arguing that provisions should cover expected losses and that capital requirements should cover potential losses beyond expected losses subject to some statistical level of tolerance the article assesses how well actual capital and provisioning requirements match the estimated requirements given by the model actual provisioning requirements were found to be close to implied levels of expected losses the estimate of potential losses was found to be highly sensitive to the assumptions of the model especially the parameter relating the volatility of a loan s rate of default to its mean value this volatility parameter cannot be estimated accurately with the credit bureau data because of the short time span covered so proxy data were used to estimate it and two values around that estimate

the interaction between the financial and investment decisions of the firm the case of issuing warrants in a levered firm abstract in this paper we analyze the value of warrants and stock in a firm that has both equity and debt in its capital structure and assume that the proceeds from exercising the warrants are reinvested in the firm the effect of potential future scale investment on the firm s stock debt and warrants are investigated the warrants in our analysis are european in this framework there are two sources for the nonstationarity of the rate of return on any kind of financial claim the first stems from changes in the firm s capital structure and the second is due to the potential scale increase in the value of the firm should the warrants be exercised the effect of a potential transfer of wealth from equity holders to debt holders at time of exercise is analyzed when warrants are exercised and the proceeds are reinvested in a scale expansion project the probability of default may decrease it follows therefore that ceteris paribus debt is likely to appreciate in value at the expense of equity the method of pricing by arbitrage as proposed by harrison and kreps is used to derive values for claims on the firm problems associated with measuring the volatility of equity are discussed

evaluating credit risk models over the past decade commercial banks have devoted many resources to developing internal models to better quantify their financial risks and assign economic capital these eaorts have been recognized and encouraged by bank regulators recently banks have extended these eaorts into the field of credit risk modeling however an important question for both banks and their regulators is evaluating the accuracy of a model s forecasts of credit losses especially given the small number of available forecasts due to their typically long planning horizons using a panel data approach we propose evaluation methods for credit risk models based on cross sectional simulation specifically models are evaluated not only on their forecasts over time but also on their forecasts at a given point in time for simulated credit portfolios once the forecasts corresponding to these portfolios are generated they can be evaluated using various statistical methods 2000 elsevier science b v all rights reserved

a multi factor credit migration model for sovereign and corporate debts abstract this paper develops a multi factor markov chain model for rating migrations and credit spreads that is applicable to both sovereign and corporate debts the model s central feature is to allow transition matrices to be time varying and driven by rating specific latent variables which encompass economic factors like the business cycle there are three main contributions first the model incorporates well documented empirical properties of transition matrices such as their dependence on business credit cycles and it also allows for inter rating variations in credit quality changes second instead of focusing solely on empirical modeling of rating transitions the paper also shows how the empirical model can be implemented for actual valuations third the estimation and calibration procedures are easy to follow and implement

a coupled markov chain approach to credit risk modeling we propose a markov chain model for credit rating changes we do not use any distributional assumptions on the asset values of the rated companies but directly model the rating transitions process the parameters of the model are estimated by a maximum likelihood approach using historical rating transitions and heuristic global optimization techniques we benchmark the model against a glmm model in the context of bond portfolio risk management the proposed model yields stronger dependencies and higher risks than the glmm model as a result the risk optimal portfolios are more conservative than the decisions resulting from the benchmark model

an integrated pricing model for defaultable loans and bonds abstract in recent years credit risk has played a key role in risk management issues practitioners academics and regulators have been fully involved in the process of developing studying and analysing credit risk models in order to find the elements which characterize a sound risk management system in this paper we present an integrated model based on a reduced pricing approach for market and credit risk its main features are those of being mark to market and that the spread term structure by rating class is contingent on the seniority of debt within an arbitrage free framework we introduce issues such as the integration of market and credit risk the use of stochastic recovery rates and recovery by seniority moreover we will characterize default risk by estimating migration risk through a mortality rate actuarial based approach the resultant probabilities will be the base for determining multi period risk neutral transition probability that allow pricing of risky debt in the trading and banking book

trade credit for supply chain coordination abstract trade credit is a seller s short term loan to the buyer allowing the buyer to delay payment of an invoice it has been the largest source of working capital for a majority of business to business firms in the united states numerous theories have been proposed to explain trade credit mainly from finance perspectives it has also been an important issue in supply chain management surprisingly most literature in supply chain management has examined the retailer s stocking policies given a supplier s trade credit this paper attempts to shed light on trade credit from a supplier s perspective and presents it as a tool for supply chain coordination specifically we explicitly assume firms financial needs for inventory following a newsvendor framework we assume that the supplier grants trade credit and markdown allowance given the supplier s offer the retailer determines order quantity and the financing option for the inventory either trade credit or direct financing from a financial institution our result shows that the supplier s markdown allowance alone cannot fully coordinate the supply chain if the retailer employs direct financing positive financing costs call for trade credit in order to subsidize the retailer s costs of inventory financing using trade credit in addition to markdown allowance the supplier fully coordinates the retailer s decisions for the largest joint profit and extracts a greater portion of the maximized joint profit

the effects of estimation error on measures of portfolio credit risk abstract this paper uses monte carlo simulations to assess the impact of noisy input parameters on the accuracy of estimated portfolio credit risk assumptions about input quality are derived from the distribution of historical sample statistics commonly used in default risk modelling the resulting estimation error in the distribution of portfolio losses is considerable losses that are judged to occur with a probability of 0 3 may actually occur with a probability of 1 the paper also shows that estimation error leads to biases in value at risk estimates and significance levels of backtests the biases can be corrected by analysing predictive distributions which average over the unknown parameter values

the domino effect of credit defaults test of asymmetric default correlations using realised default data using the research framework of a domino effect in firms we first make theoretical contributions by addressing several testable hypotheses regarding asymmetrical default correlations we then employ lucas s method to provide empirical evidence based on realised historical default data in the united states from 1992 to 2013 our empirical results are consistent with the following notions first default correlations increase with the time horizon second firms with low credit quality small size illiquidity and a high beta exhibit higher default correlations credit risk management without considering asymmetrical default correlations could underestimate portfolio risk due to default clustering

var and expected shortfall in portfolios of dependent credit risks conceptual and practical insights in the first part of this paper we address the non coherence of value at risk var as a risk measure in the context of portfolio credit risk and highlight some problems which follow from this theoretical deficiency in particular a realistic demonstration of the non subadditivity of var is given and the possibly nonsensical consequences of var based portfolio optimisation are shown the second part of the paper discusses var and expected shortfall estimation for large balanced credit portfolios all standard industry models creditmetrics kmv creditrisk are presented as bernoulli mixture models to facilitate their direct comparison for homogeneous groups it is shown that measures of tail risk for the loss distribution may be approximated in large portfolios by analysing the tail of the mixture distribution in the bernoulli representation an example is given showing that for portfolios of lower quality choice of model has some impact on measures of extreme risk 2002 elsevier science b v all rights reserved

sorting out risks using known apt factors arbitrage pricing theory apt differs from the capital asset pricing model capm in hypothesizing that actual and expected security returns are sensitive not to just one type of nondiversifiable risk i e beta or market risk but to a variety of different ypes of risk prior testing has shown the capm to be inferior to an apt model that incorporates unanticipated changes in five macroeconomic variables default risk the term structure of interest rates inflation or deflation the long run expected growth rate of profits for the economy and residual market risk it is possible to estimate the sensitivities of individual securities or portfolios to these five risk factors such measurements allow one to explore variations in sensitivities to different types of risk across both equity market sectors and industries the resulting risk exposure profiles do not depend on any particular market index apt risk profiles may be used for either active or passive portfolio management passive managers wishing to reduce their portfolios systematic risk characteristics might consider a technique termed risk sterilization here assets with different risk profiles are combined so as to negate or sterilize exposure to selected riskfactors alternatively active managers can attempt to achieve excess returns by constructing portfolios in accordance with their forecasts of risk factor realizations

bank ratings what determines their quality this paper examines the quality of credit ratings assigned to banks by the three largest rating agencies we interpret credit ratings as relative assessments of creditworthiness and define a new ordinal metric of rating error based on banks expected default frequencies our results suggest that on average large banks receive more positive bank ratings particularly from the agency to which the bank provides substantial securitization business these competitive distortions are economically significant and contribute to perpetuate the existence of too big to fail banks we also show that overall differential risk weights recommended by the basel accords for investment grade banks bear no significant relationship to empirical default probabilities harald hau sam langfield and david marques ibanez

risk based capital requirements for mortgage loans abstract we contribute to the debate over the reform of the basel accord by developing risk based capital requirements for mortgage loans held in portfolio by financial intermediaries our approach employs simulation of both economic variables that affect default incidence and conditional loss probability distributions results indicate that appropriate capital charges for credit risk vary substantially with loan characteristics and portfolio geographic diversification hence rules that offer little risk differentiation including the current basel i regime and standardized approach proposed in basel ii result in significant divergence between regulatory and economic capital these results highlight the incentive problems inherent in simplified methods of capital regulation

credit risk models and agricultural lending credit risk models are developed and used to estimate capital requirements for agricultural lenders under the new basel capital accord the study uses credit value at risk methods to calculate probability of default loss given default and expected and unexpected losses two applied models creditmetrics and moody s kmv are estimated using farm financial data the results show that the necessary capital for agricultural lenders under the new basel accord varies substantially depending on the riskiness and granularity of the portfolio

credit risk analysis of mortgage loans an application to the italian market the valuation of financial instruments in which both credit risk and interest rate risk are taken into account is an outstanding task for financial institutions in this paper we propose an affine reduced model dealing with this topic we show that this model offers analytical tractability as well as flexibility we also show that the parameters of the model can be estimated via maximum likelihood in a straightforward way to outline the procedure we estimate the model on italian data using zero coupon bond and historical default probabilities as provided by the bank of italy

coordination risk and the price of debt abstract creditors of a distressed borrower face a coordination problem even if the fundamentals are sound fear of premature foreclosure by others may lead to pre emptive action undermining the project recognition of this problem lies behind corporate bankruptcy provisions across the world and it has been identified as a culprit in international financial crises but has received scant attention from the literature on debt pricing without common knowledge of fundamentals the incidence of failure is uniquely determined provided that private information is precise enough this affords a way to price the coordination failure comparative statics on the unique equilibrium provides several insights on the role of information and the incidence of inefficient liquidation

the collateral value of fine art in this paper we examine the effect of implicit seller reserves on the estimation of value at risk based on historical asset sales data we direct our examination toward how and whether fine art might prove an appropriate form of loan collateral for banks and other financial institutions using a data set of french impressionist paintings brought to auction from 1985 to 2001 we control for the effect of works that are bought in house to construct a distribution of potential sale values that corrects for sample selection bias it turns out that the downside risk surrounding deviations of auction prices from expert presale estimates depends critically on how buy ins are incorporated if downside risk is assessed solely on historical experience with successful auction sales the data appear to support loan to value ratios between 50 and a 100 larger than loan to value ratios that countenance the existence of seller reserves the auction process however is quantifiable and can reveal the necessary risk information required for loan consideration

fiscal inertia donor credibility and the monetary management of aid surges abstract donors cannot pre commit to support scaled up public spending programs on a continuing basis nor can governments credibly commit to curtail expenditure rapidly in the event that aid revenues contract an aid boom may therefore be accompanied by a credibility problem when this is the case the absorb and spend strategy recommended by the imf leads to capital flight higher inflation and large current account surpluses inclusive of aid the right policy package combines a critical minimum degree of fiscal restraint with reverse sterilization