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on Risk Management |
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Issue of 2021‒05‒24
twenty-one papers chosen by |
| By: | Galaasen, Sigurd; Jamilov, Rustam; Juelsrud, Ragnar Enger; Rey, Hélène |
| Abstract: | What is the impact of granular credit risk on banks and on the economy? We provide the first causal identification of single-name counterparty exposure risk in bank portfolios by applying a new empirical approach on an administrative matched bank-firm dataset from Norway. Exploiting the fat tail properties of the loan share distribution we use a Gabaix and Koijen (2020a,b) granular instrumental variable strategy to show that idiosyncratic borrower risk survives aggregation in banks portfolios. We also find that this granular credit risk spills over from affected banks to firms, decreases investment, and increases the probability of default of non-granular borrowers, thereby sizably affecting the macroeconomy. |
| Keywords: | aggregation; financial intermediaries; granularity; systemic risk |
| JEL: | G20 |
| Date: | 2020–10 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15385&r= |
| By: | Acharya, Viral V.; Iyer, Aaditya M.; Sundaram, Rangarajan K |
| Abstract: | We address the paradox that financial innovations aimed at risk-sharing appear to have made the world riskier. Financial innovations facilitate hedging idiosyncratic risks among agents; however, aggregate risks can be hedged only with liquid assets. When risk-sharing is primitive, agents self-hedge and hold more liquid assets; this buffers aggregate risks, resulting in few correlated failures compared to when there is greater risk sharing. We apply this insight to build a model of a clearinghouse to show that as risk-sharing improves, aggregate liquidity falls but correlated failures rise. Public liquidity injections, for example, in the form of a lender-of-last-resort can reduce this systemic risk ex post, but induce lower ex-ante levels of private liquidity, which can in turn aggravate welfare costs from such injections. |
| JEL: | G21 G22 G31 |
| Date: | 2020–09 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15269&r= |
| By: | Karoline Bax; \"Ozge Sahin; Claudia Czado; Sandra Paterlini |
| Abstract: | While environmental, social, and governance (ESG) trading activity has been a distinctive feature of financial markets, the debate if ESG scores can also convey information regarding a company's riskiness remains open. Regulatory authorities, such as the European Banking Authority (EBA), have acknowledged that ESG factors can contribute to risk. Therefore, it is important to model such risks and quantify what part of a company's riskiness can be attributed to the ESG ratings. This paper aims to question whether ESG scores can be used to provide information on (tail) riskiness. By analyzing the (tail) dependence structure of companies with a range of ESG scores, using high-dimensional vine copula modelling, we are able to show that risk can also depend on and be directly associated with a specific ESG rating class. Empirical findings on real-world data show positive not negligible dependencies between clusters determined by ESG scores, especially during the 2008 crisis. |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2105.07248&r= |
| By: | Gourinchas, Pierre-Olivier; Kalemli-Ozcan, Sebnem; Penciakova, Veronika; Sander, Nick |
| Abstract: | We estimate the impact of the COVID-19 crisis on business failures among small and medium size enterprises (SMEs) in seventeen countries using a large representative firm-level database. We use a simple model of firm cost-minimization and measure each firm's liquidity shortfall during and after COVID-19. Our framework allows for a rich combination of sectoral and aggregate supply, productivity, and demand shocks. We estimate a large increase in the failure rate of SMEs under COVID-19 of nearly 9 percentage points, absent government support. Accommodation & Food Services, Arts, Entertainment & Recreation, Education, and Other Services are among the most affected sectors. The jobs at risk due to COVID-19 related SME business failures represent 3.1 percent of private sector employment. Despite the large impact on business failures and employment, we estimate only moderate effects on the financial sector: the share of Non Performing Loans on bank balance sheets would increase by up to 11 percentage points, representing 0.3 percent of banks' assets and resulting in a 0.75 percentage point decline in the common equity Tier-1 capital ratio. We evaluate the cost and effectiveness of various policy interventions. The fiscal cost of an intervention that narrowly targets at risk firms can be modest (0.54% of GDP). How- ever, at a similar level of effectiveness, non-targeted subsidies can be substantially more expensive (1.82% of GDP). Our results have important implications for the severity of the COVID-19 recession, the design of policies, and the speed of the recovery. |
| Keywords: | bankruptcy; business failure; COVID-19; SMEs |
| Date: | 2020–09 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15323&r= |
| By: | Dodo Natatou Moutari; Hassane Abba Mallam; Diakarya Barro; Bisso Saley |
| Abstract: | This study aims to widen the sphere of pratical applicability of the HAC model combined with the ARMA-APARCH volatility forecast model and the extreme values theory. A sequential process of modeling of the VaR of a portfolio based on the ARMA-APARCH-EVT-HAC model was discussed. The empirical analysis conducted with data from international stock market indices clearly illustrates the performance and accuracy of modeling based on HACs. |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2105.09473&r= |
| By: | Claudia Ceci; Katia Colaneri; Alessandra Cretarola |
| Abstract: | We study optimal proportional reinsurance and investment strategies for an insurance company which experiences both ordinary and catastrophic claims and wishes to maximize the expected exponential utility of its terminal wealth. We propose a model where the insurance framework is affected by environmental factors, and aggregate claims and stock prices are subject to common shocks, i.e. drastic events such as earthquakes, extreme weather conditions, or even pandemics, that have an immediate impact on the financial market and simultaneously induce insurance claims. Using the classical stochastic control approach based on the Hamilton-Jacobi-Bellman equation, we provide a verification result for the value function via classical solutions to two backward partial differential equations and characterize the optimal reinsurance and investment strategies. Finally, we make a comparison analysis to discuss the effect of common shock dependence. |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2105.07524&r= |
| By: | Bedayo, Mikel; Jiménez, Gabriel; Peydró, José Luis; Vegas, Raquel |
| Abstract: | We show that loan origination time is key for bank lending standards, cycles, defaults and failures. We exploit the credit register from Spain, with the time of a loan application and its granting. When VIX is lower (booms), banks shorten loan origination time, especially to riskier firms. Bank incentives (capital and competition), capacity constraints, and borrower-lender information asymmetries are key mechanisms driving results. Moreover, shorter (loan-level) origination time is associated with higher ex-post defaults, also using variation from holidays. Finally, shorter precrisis origination time -more than other lending conditions- is associated with more bank-level failures in crises, consistent with lower screening. |
| Keywords: | bank failures; Credit cycles; Defaults; Lending standards; loan origination time; screening |
| JEL: | E44 E51 G01 G21 G28 |
| Date: | 2020–11 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15445&r= |
| By: | Bruno P. C. Levy; Hedibert F. Lopes |
| Abstract: | We propose a fast and flexible method to scale multivariate return volatility predictions up to high-dimensions using a dynamic risk factor model. Our approach increases parsimony via time-varying sparsity on factor loadings and is able to sequentially learn the use of constant or time-varying parameters and volatilities. We show in a dynamic portfolio allocation problem with 455 stocks from the S&P 500 index that our dynamic risk factor model is able to produce more stable and sparse predictions, achieving not just considerable portfolio performance improvements but also higher utility gains for the mean-variance investor compared to the traditional Wishart benchmark and the passive investment on the market index. |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2105.06584&r= |
| By: | Nicolas Veron (Bruegel and Peterson Institute); Anna Gelpern (Georgetown University); Lynn Shibut (Federal Deposit Insurance Corporation); Marco Bodellini (Queen Mary University); Michael Schillig (King's College University); Margit Vanberg (Bafin); Sven Balder (Bafin); Francisco Sotelo (Bank of Spain); Jens Verner Andersen (Finansiel Stabilitet); Mathias Semay Hovedskov (Finansiel Stabilitet); Fernando Restoy (Financial Stability Institute); Rastko Vrbaski (Financial Stability Institute); Ruth Walters (Financial Stability Institute) |
| Abstract: | The volume is a collection of the papers presented at the workshop organized by the Bank of Italy on 'The crisis management framework for banks in the EU - how can we deal with the crisis of small and medium-sized banks?', held online on 15 January 2021.The workshop provided the opportunity to reflect on the possible reforms of EU rules to increase the capacity of the authorities to manage the crises of small and medium-sized banks so as to avoid a destroying-value peicemeal liquidation and the overall costs that it could generate |
| Keywords: | bank resolution, BRRD, bank insolvency, banking union, small banks, resolution framework |
| JEL: | G20 G21 G28 G01 |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:bdi:workpa:sec_24&r= |
| By: | Dumas, Bernard J; Gabuniya, Tymur; Marston, Richard C |
| Abstract: | The distinction between domicile and place of business is becoming more and more relevant as a growing number of firms have activities abroad. In most statistical studies of international stock returns, a firm is included in a country's index if its headquarters are located in that country. This classification scheme ignores the operations of the firm. We propose, instead, to measure the firms's exposures to "geographic zones" according to the place where they conduct business. As a representation of "geographic risks", we synthesize zone factors from all firms in the dataset, be they domestic firms or multinationals. And we show the properties of the exposures to the zone factors. |
| Keywords: | country factors; expectations-maximization algorithm; factor models; geographic investing; stock return exposures; stock return indexes |
| JEL: | C4 F3 F6 G1 |
| Date: | 2020–11 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15503&r= |
| By: | Ludovic Cal\`es; Apostolos Chalkis; Ioannis Z. Emiris |
| Abstract: | This paper aims to develop new mathematical and computational tools for modeling the distribution of portfolio returns across portfolios. We establish relevant mathematical formulas and propose efficient algorithms, drawing upon powerful techniques in computational geometry and the literature on splines, to compute the probability density function, the cumulative distribution function, and the k-th moment of the probability function. Our algorithmic tools and implementations efficiently handle portfolios with 10000 assets, and compute moments of order k up to 40 in a few seconds, thus handling real-life scenarios. We focus on the long-only strategy which is the most common type of investment, i.e. on portfolios whose weights are non-negative and sum up to 1; our approach is readily generalizable. Thus, we leverage a geometric representation of the stock market, where the investment set defines a simplex polytope. The cumulative distribution function corresponds to a portfolio score capturing the percentage of portfolios yielding a return not exceeding a given value. We introduce closed-form analytic formulas for the first 4 moments of the cross-sectional returns distribution, as well as a novel algorithm to compute all higher moments. We show that the first 4 moments are a direct mapping of the asset returns' moments. All of our algorithms and solutions are fully general and include the special case of equal asset returns, which was sometimes excluded in previous works. Finally, we apply our portfolio score in the design of new performance measures and asset management. We found our score-based optimal portfolios less concentrated than the mean-variance portfolio and much less risky in terms of ranking. |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2105.06573&r= |
| By: | Chavleishvili, Sulkhan; Fahr, Stephan; Kremer, Manfred; Manganelli, Simone; Schwaab, Bernd |
| Abstract: | Macroprudential policymakers assess medium-term downside risks to the real economy arising from financial imbalances and implement policies aimed at managing those risks. In doing so, they face an inherent intertemporal trade-off between the expected growth and downside risks. This paper reviews the literature on Growth-at-Risk, embeds it in the wider literature on macroprudential policy, and proposes an empirical risk management framework that combines insights from the two literatures, by forecasting the entire real GDP growth distribution with a structural quantile vector autoregressive model. It accounts for direct and indirect interactions between financial vulnerabilities, financial stress and real GDP growth and allows for potential non-linear amplification effects. The framework provides policymakers with a macro-financial stress test to monitor downside risks to the economy and a macroprudential stance metric to quantify when interventions may be beneficial. JEL Classification: G21, C33 |
| Keywords: | financial conditions, growth-at-risk, macroprudential policy, quantile vector autoregression, stress testing |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20212556&r= |
| By: | Kok, Christoffer; Müller, Carola; Ongena, Steven; Pancaro, Cosimo |
| Abstract: | Using a difference-in-differences approach and relying on confidential supervisory data and an unique proprietary data set available at the European Central Bank related to the 2016 EU-wide stress test, this paper presents novel empirical evidence that supervisory scrutiny associated to stress testing has a disciplining effect on bank risk. We find that banks that participated in the 2016 EU-wide stress test subsequently reduced their credit risk relative to banks that were not part of this exercise. Relying on new metrics for supervisory scrutiny that measure the quantity, potential impact, and duration of interactions between banks and supervisors during the stress test, we find that the disciplining effect is stronger for banks subject to more intrusive supervisory scrutiny during the exercise. JEL Classification: G11, G21, G28 |
| Keywords: | banking regulation, banking supervision, credit risk, internal models, stress testing |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20212551&r= |
| By: | Dicks, David; Fulghieri, Paolo |
| Abstract: | We study a multidivisional firm where headquarters are exposed to moral hazard by division managers under uncertainty (or "ambiguity") aversion. We show the aggregation and linearity results of Holmström and Milgrom (1987) hold in an environment with IID ambiguity, as in Chen and Epstein (2002). While uncertainty creates endogenous disagreement that aggravates moral hazard, by hedging uncertainty headquarters can design incentive contracts that reduce disagreement, lower incentive provision costs, and promote effort. Because hedging uncertainty can conflict with hedging risk, optimal contracts differ from standard principal-agent models. Optimal contracts involve exposure to other divisions even when division cash flows are uncorrelated and, with sufficient uncertainty, involve equity-based pay, even when division cash-flows are positively correlated. Our model helps explain the prevalence of equity-based incentive contracts and the rarity of relative performance contracts. |
| Keywords: | Ambiguity; incentive contracting |
| Date: | 2020–10 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15378&r= |
| By: | Bartosz Jaroszkowski; Max Jensen |
| Abstract: | We propose a model to quantify the effect of parameter uncertainty on the option price in the Heston model. More precisely, we present a Hamilton-Jacobi-Bellman framework which allows us to evaluate best and worst case scenarios under an uncertain market price of volatility risk. For the numerical approximation the Hamilton--Jacobi--Bellman equation is reformulated to enable the solution with a finite element method. A case study with butterfly options exhibits how the dependence of Delta on the magnitude of the uncertainty is nonlinear and highly varied across the parameter regime. Keywords: Uncertain market price, Volatility risk, Hamilton-Jacobi-Bellman equation, Finite element method, Uncertainty quantification |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2105.09581&r= |
| By: | Eichenbaum, Martin; Godinho de Matos, Miguel; Lima, Francisco; Rebelo, Sérgio; Trabandt, Mathias |
| Abstract: | We study how people react to small probability events with large negative consequences using the outbreak of the COVID-19 epidemic as a natural experiment. Our analysis is based on a unique administrative data set with anonymized monthly expenditures at the individual level. We find that older consumers reduced their spending by more than younger consumers in a way that mirrors the age dependency in COVID-19 case-fatality rates. This differential expenditure reduction is much more prominent for high-contact goods than for low-contact goods and more pronounced in periods with high COVID-19 cases. Our results are consistent with the hypothesis that people react to the risk of contracting COVID-19 in a way that is consistent with a canonical model of risk taking. |
| Keywords: | COVID-19; risk |
| JEL: | E21 I10 |
| Date: | 2020–10 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15373&r= |
| By: | David Adeabah (University of Ghana, Legon, Ghana); Charles Andoh (University of Ghana, Legon, Ghana); Simplice A. Asongu (Yaoundé, Cameroon); Albert Gemegah (University of Ghana, Legon, Ghana) |
| Abstract: | Reputation is an important factor for long-term stability, competitiveness, and success of all contemporary organizations. It is even more important for banks because of their systemic role in a modern economy. In this study, we present a review of the current body of literature regarding reputational risks in banks. Using the systematic literature review method, 35 articles published from 2010 to 2020 are reviewed and analyzed. It was found that only developed countries (i.e., the United States and Europe) have been actively contributing to research on reputational risks in banks, suggesting that reputational risks management of banks has not gained the global attention it deserves. Additionally, issues of mitigation of reputational risks are identified as the most frequently studied research theme with a paucity of research on measurement, determinants, and implications of reputational risks at both micro and macro levels. Furthermore, it was noticed that reputational risk management frameworks are still underdeveloped. In theory, this review should help with a strong conceptualization of reputational risks management in banks and guide further research. |
| Keywords: | reputational risks; banks; systematic literature review |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:agd:wpaper:21/028&r= |
| By: | Röthke, Konstantin; Albrecht, Gregor; Adam, Martin; Benlian, Alexander |
| Date: | 2021–05–13 |
| URL: | http://d.repec.org/n?u=RePEc:dar:wpaper:126523&r= |
| By: | Alok Johri (McMaster University); Shahed Khan (University of Western Ontario); César Sosa-Padilla (University of Notre Dame/NBER) |
| Abstract: | International data suggests that fluctuations in the level and volatility of the world interest rate (as measured by the US treasury bill rate) are positively correlated with both the level and volatility of sovereign spreads in emerging economies. We incor- porate an estimated time-varying process for the world interest rate into a model of sovereign default calibrated to a panel of emerging economies. Time variation in the world interest rate interacts with default incentives in the model and leads to state con- tingent effects on borrowing and sovereign spreads which resemble those found in the data. The model delivers up to one-half of the positive comovement between the level and volatility of world interest rate and the level of sovereign spreads seen in emerg- ing economies. Moreover, the model also delivers significant positive co-movements between the volatility of the spread and the process for the world interest rate which is also consistent with the data. Our model provides one potential source for the observed bunching in default probabilities observed across nations, namely the world interest rate process. Our model generates a positive and significant correlation (0.51) between the spreads of two nations with uncorrelated income processes. This is close to the observed mean correlation in the data (0.61). |
| Keywords: | Sovereign Debt Sovereign Default Interest Rate Spread Time-varying Volatility Uncertainty Shocks |
| JEL: | F34 F41 E43 E32 |
| Date: | 2020–12 |
| URL: | http://d.repec.org/n?u=RePEc:aoz:wpaper:31&r= |
| By: | Thomas Krabichler; Marcus Wunsch |
| Abstract: | Goal-based investing is concerned with reaching a monetary investment goal by a given deadline, which differs from mean-variance optimization in modern portfolio theory. In this article, we expand the close connection between goal-based investing and option hedging that was originally discovered in [Bro99b] by allowing for varying degrees of investor risk aversion using lower partial moments of different orders. Moreover, we show that maximizing the probability of reaching the goal (quantile hedging, cf. [FL99]) and minimizing the expected shortfall (efficient hedging, cf. [FL00]) yield, in fact, the same optimal investment policy. Finally, we develop an innovative approach to goal-based investing using methods of reinforcement learning, demonstrating its flexibility vis-\`a-vis general market dynamics incorporating transaction costs. |
| Date: | 2021–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2105.07915&r= |
| By: | Davis, Steven J; Hansen, Stephen; Seminario-Amez, Cristhian |
| Abstract: | Firm-level stock returns differ enormously in reaction to COVID-19 news. We characterize these reactions using the Risk Factors discussions in pre-pandemic 10-K filings and two text-analytic approaches: expert-curated dictionaries and supervised machine learning (ML). Bad COVID-19 news lowers returns for firms with high exposures to travel, traditional retail, aircraft production and energy supply -- directly and via downstream demand linkages -- and raises them for firms with high exposures to healthcare policy, e-commerce, web services, drug trials and materials that feed into supply chains for semiconductors, cloud computing and telecommunications. Monetary and fiscal policy responses to the pandemic strongly impact firm-level returns as well, but differently than pandemic news. Despite methodological differences, dictionary and ML approaches yield remarkably congruent return predictions. Importantly though, ML operates on a vastly larger feature space, yielding richer characterizations of risk exposures and outperforming the dictionary approach in goodness-of-fit. By integrating elements of both approaches, we uncover new risk factors and sharpen our explanations for firm-level returns. To illustrate the broader utility of our methods, we also apply them to explain firm-level returns in reaction to the March 2020 Super Tuesday election results. |
| Date: | 2020–09 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:15314&r= |