Knowledge that Transforms

One of the most important policy issues for financial authorities is to decide at what level average capital charges should be set. The decision may alternatively be expressed as the choice of an appropriate survival probability for representative banks over a horizon such as a year, often termed a “solvency standard”. This article sheds light on the solvency standards implied by current and possible future G10 bank regulation and on the “economic solvency standard” that banks choose themselves by their own capital setting decisions. In particular, we employ a credit risk model to show that the survival probability implied by the 1988 Basel Accord is between 99.0% and 99.9%. We then demonstrate that if a new Basel Accord were calibrated to such a standard, it would not represent a binding constraint on banks' current operations since most banks employ a solvency standard higher than 99.9%. To show this, we employ a statistical analysis of bank ratings adjusted for the impact of official or other support as well as credit risk model calculations. Lastly, we advance a possible explanation for the conservative capital choices made by banks by showing that swap volumes are highly correlated with credit quality for given bank size. This suggests that banks' access to important credit markets like the swaps markets may provide a significant discipline in the choice of solvency standard.

Theory suggests that uninsurable income risk induces individuals to accumulate assets as a precautionary reserve of value. Most assets, however, bear rate of return risk, that can be diversified only if every asset is traded by a large number of individuals and arbitrage is frictionless. Using Italian micro-data, we find evidence of income and asset risks that affect consumption. Italian households are particularly well insured against illness but not against job losses. Moreover, we detect a positive, yet weak, effect of asset holding on the variability of consumption streams across households.

I look at `trust' in the light of two constructions taken from economic science: general competitive analysis and the theory of games. I draw on Baier's anti-contractarian perspective, as well as on one informed by Wittgenstein's writings. The former focuses on relations between inherently unequal and asymmetrical individuals, while the latter draws on and revolves around the imperative in the Philosophical Investigations: “Let the use teach you the meaning” [p. 212; also p. 220]. I try to spell out how the choice of language has epistemological implications: for an analysis of trust, for the trustworthiness of the scientific constructions I use for analyzing trust, and thereby, more generally, for defining `ourselves' and our `form of life.'

We consider the estimation of credit rating transitions based on continuous-time observations. Through simple examples and using a large data set from Standard and Poor's, we illustrate the difference between estimators based on discrete-time cohort methods and estimators based on continuous observations. We apply semi-parametric regression techniques to test for two types of non-Markov effects in rating transitions: Duration dependence and dependence on previous rating. We find significant non-Markov effects, especially for the downgrade movements.

The growth of US credit unions during the 1990s is investigated empirically, using univariate and multivariate cross sectional and panel estimation techniques. Univariate tests of the law of proportionate effect suggest that in general large credit unions grew faster than their smaller counterparts. On average credit unions with above-average growth in one period tended to experience below-average growth in the next. Smaller credit unions tended to have more variable growth than large ones. While credit unions share a common co-operative philosophy, they differ in terms of age profile, scope for membership growth, charter type and financial structure and performance. In estimations of a multivariate growth model, most of these characteristics are found to have a significant influence on the size-growth relationship. While large state chartered credit unions grew faster than their smaller counterparts, the reverse was true for federally chartered credit unions. In general, if larger credit unions grew faster than smaller ones, they tended to do so for specific reasons: because their charters were less restrictive, because they were more efficient, or because they had a financial structure that was more conducive to growth. Therefore credit union growth was not `random', but highly systematic.

We study a space of coherent risk measures Mφ obtained as certain expansions of coherent elementary basis measures. In this space, the concept of “risk aversion function” φ naturally arises as the spectral representation of each risk measure in a space of functions of confidence level probabilities. We give necessary and sufficient conditions on φ for Mφ to be a coherent measure. We find in this way a simple interpretation of the concept of coherence and a way to map any rational investor's subjective risk aversion onto a coherent measure and vice-versa. We also provide for these measures their discrete versions M(N)φ acting on finite sets of N independent realizations of a r.v. which are not only shown to be coherent measures for any fixed N, but also consistent estimators of Mφ for large N.

Studies have focused heavily on money in the transmission mechanism of monetary policy. In this article we explore the empirical importance of credit. The paper provides a framework in which to analyse the balance sheets of, and financial flows between, different sectors of the UK economy, and an econometric model of the interactions between non-financial firms, households and credit offered by banks and non-bank financial intermediaries. The paper also provides a dynamic structural model of bank and building society credit, money and decisions to consume and invest and then adds credit from non-bank financial intermediaries. Our bottom line is that credit is an important part of the transmission process of UK monetary policy.

Risk managers are increasingly required by international Regulatory Institutions to adopt accurate techniques for the measurement and control of portfolios financial risks. The task requires first the identification of the different risk sources affecting the portfolio and the measurement of their impact, then after: the adoption of appropriate portfolio strategies aimed at neutralising these risks. The comprehensive concept of Value-at-Risk (VaR) as a maximum tolerable loss, with a given confidence interval, has become in this regard the industry standard in risk management. In the paper we focus on the implications of different risk measurement techniques and portfolio optimisation strategies in presence of markets subject to periods of severe instability, resulting in significant deviations of financial returns from the Normality assumption typically adopted in mainstream finance. Comparative results on 1 day-VaR(99%) estimation are presented over a range of bond and equity markets with different risk profiles. The reference period of our analysis includes several market shocks and in particular the Argentinean Eurobond crisis of July 2001. The solution of an optimal portfolio problem over the crisis period is discussed within a [mean, variance, VaR99%] portfolio space, emphasising the difficulty of the portfolio's relative return maximisation problem faced by fund managers.

This study investigates the dynamic interdependence of the major stock markets in Latin America. Using data from 1995 to 2000, we examine the stock market indexes of Argentina, Brazil, Chile, Colombia, Mexico and Venezuela. The index level series are non-stationary and so we employ cointegration analysis and error correction vector autoregressions (VAR) techniques to model the interdependencies. We find that there is one cointegrating vector which appears to explain the dependencies in prices. The results are robust to sensitivity tests based on translating indexes to US dollars (i.e., a common currency for all the markets) and to partitioning the sample into periods before and after the Asian and Russian financial crises of 1997 and 1998, respectively. Our results suggest that the potential for diversifying risk by investing in different Latin American markets is limited.