Knowledge that Transforms

In the wake of the subprime crisis of 2007 which uncovered shortfalls in capital levels of most financial institutions, the Basel Committee planned to strengthen current regulations contained in Basel II. While maintaining the Internal Model Approach based on Value-at-Risk, a stressed VaR calculated over highly strung periods is to be added to present directives to constitute Minimum Capital Requirements. Consequently, the adoption of the appropriate VaR specification remains a subject of paramount importance as it determines the financial condition of the firm. In this article I explore the performance of several models to compute MCR in the context of Emerging and Frontier stock markets within the present and proposed capital structures. Considering the evidence gathered, two major contributions arise: (a) heavy-tailed distributions – particularly Extreme Value (EV) ones-, reveal as the most accurate technique to model market risks, hence preventing huge capital deficits under current measures; (b) the application of such methods could allow slight modifications to present mandate and simultaneously avoid sVaR or at least reduce its scope, thus mitigating the impact regarding the enhancement of capital base. Therefore, I suggest that the inclusion of EV in planned supervisory accords should reduce development costs and foster healthier financial structures.

This paper investigates macro stress testing of system-wide credit risk with special focus on the tails of the credit risk distributions conditional on adverse macroeconomic scenarios. These tails determine the ex-post solvency probabilities derived from the scenarios. This paper estimates the macro-credit risk link by the traditional Wilson, 1997a, Wilson, 1997b model as well as by an alternative proposed quantile regression (QR) method (Koenker and Xiao, 2002), in which the relative importance of the macro variables can vary along the credit risk distribution, conceptually incorporating uncertainty in default correlations. Stress-testing exercises on the Brazilian household sector at the one-quarter horizon indicate that unemployment rate distress produces the most harmful effect, whereas distressed inflation and distressed interest rate show higher impacts at longer periods. Determining which of the two stress-testing approaches perceives the scenarios more severely depends on the type of comparison employed. The QR approach is revealed more conservative based on a suggested comparison of vertical distances between the tails of the conditional and unconditional credit risk cumulative distributions.

This paper investigates the dynamics between key regulatory and supervisory policies and various aspects of commercial bank efficiency and performance for a sample of 22 EU countries over 2000–2008. In the first stage of the analysis we measure efficiency by employing the Data Envelopment Analysis (DEA) technique. In addition, we employ two distinct accounting ratios to capture the costs of intermediation (net interest margin) and cost effectiveness (cost-to-income ratio). Our regression framework includes truncated regressions and generalized linear models. Moreover, we carry out a sensitivity analysis for robustness using a fractional logit estimator. Our results show that strengthening capital restrictions and official supervisory powers can improve the efficient operations of banks. Evidence also indicates that interventionist supervisory and regulatory policies such as private sector monitoring and restricting bank activities can result in higher bank inefficiency levels. Finally, the evidence produced suggests that the beneficial effects of capital restrictions and official supervisory powers (interventionist supervisory and regulatory policies) on bank efficiency are more pronounced in countries with higher quality institutions.

This article is a review of a 531 page book that in turn is a review and evaluation of the 2319 page Dodd–Frank Wall Street Reform and Consumer Protection Act passed by Congress on July 16, 2010. The overriding theme of the book is to pose two approaches to attaining financial stability in the future. One approach is to establish a council of wise men and women supported by an army of highly skilled professional financial economists to formulate and implement regulations designed to prevent future financial crises that wreak havoc on the real economy and require financial support from taxpayers. This is the approach of the Dodd–Frank Act. The second approach proposed by the authors of this book is to design a taxing system that taxes systemically important financial institutions on the basis of their contribution to systemic risk. Borrowing ideas from the literature on the taxation of negative externalities their view is that financial institutions that create crises should pay for the clean-up. They also argue that requiring the financial polluters to pay for the creation of systemic risk will reduce the supply of systemic risk. The reader is invited to decide which approach is best.

We explore the dynamics of default cascades in a network of credit interlink-ages in which each agent is at the same time a borrower and a lender. When some counterparties of an agent default, the loss she experiences amounts to her total exposure to those counterparties. A possible conjecture in this context is that individual risk diversification across more numerous counterparties should make also systemic defaults less likely. We show that this view is not always true. In particular, the diversification of credit risk across many borrowers has ambiguous effects on systemic risk in the presence of mechanisms of loss amplifications such as in the presence of potential runs among the short-term lenders of the agents in the network.

We consider the role of the nonrecourse financing of securitization by a financial institution (FI). Our model suggests that even though the FI has the opportunity to provide liquidity support afterward, it is optimal for the FI to use the nonrecourse financing of securitization initially, because the nonrecourse security makes liquidation of the original asset more attractive for an FI that knows that the original asset is bad. However, our model also predicts that the nonrecourse financing of securitization, together with short-term maturity financing, forces the financial system to perform inefficiently in handling troubled loans and causes problems with inefficient liquidity support and overinvestment under certain conditions, despite the nonrecourse property of securitization. The theoretical results provide empirical implications for recent problems with securitized and structured finance in the United States and Europe.

We study the properties of foreign exchange risk premiums that can explain the forward bias puzzle, defined as the tendency of high-interest rate currencies to appreciate rather than depreciate. These risk premiums arise endogenously from the no-arbitrage condition relating the term structure of interest rates and exchange rates. Estimating affine (multi-currency) term structure models reveals a noticeable tradeoff between matching depreciation rates and accuracy in pricing bonds. Risk premiums implied by our global affine model generate unbiased predictions for currency excess returns and are closely related to global risk aversion, the business cycle, and traditional exchange rate fundamentals.

We investigate whether liquidity is an important price factor in the US corporate bond market. In particular, we focus on whether liquidity effects are more pronounced in periods of financial crises, especially for bonds with high credit risk, using a unique data set covering more than 20,000 bonds, between October 2004 and December 2008. We employ a wide range of liquidity measures and find that liquidity effects account for approximately 14% of the explained market-wide corporate yield spread changes. We conclude that the economic impact of the liquidity measures is significantly larger in periods of crisis, and for speculative grade bonds.

We investigate whether the diversification discount occurs partly as an artifact of poor corporate governance. In panel data models, we find that the discount narrows by 16% to 21% when we add governance variables as regression controls. We also estimate Heckman selection models that account for the endogeneity of diversification and dynamic panel generalized method of moments models that account for the endogeneity of both diversification and governance. We find that the diversification discount persists even with these controls for endogeneity. However, in selection models the discount disappears entirely when we introduce governance variables in the second stage, and in dynamic panel GMM models the discount narrows by 37% when we include governance variables.

We construct investor sentiment indices for six major stock markets and decompose them into one global and six local indices. In a validation test, we find that relative sentiment is correlated with the relative prices of dual-listed companies. Global sentiment is a contrarian predictor of country-level returns. Both global and local sentiment are contrarian predictors of the time-series of cross-sectional returns within markets: When sentiment is high, future returns are low on relatively difficult to arbitrage and difficult to value stocks. Private capital flows appear to be one mechanism by which sentiment spreads across markets and forms global sentiment.