Showing papers in "Economic Notes in 2001"

On the Institutional Design of the European Monetary Union: Conservatism, Stability Pact and Economic Shocks

Abstract: The aim of this paper is to design the optimal institutional arrangement for a monetary union. Using a two-country rational expectations model, the study analyses how the conservatism of the area-wide central bank and the penalty system for fiscal deviation (Stability and Growth Pact) should be designed with respect to different economic shocks. The optimal institutional arrangement is also dependent on who is the ‘leader’ of the policy game. When national governments move first, the independent area-wide central bank can exercise greater discipline over national fiscal policies, making the Stability Pact unnecessary. (J.E.L.: E58, E63, F42).

Consistent High-Precision Volatility from High-Frequency Data

Abstract: Estimates of daily volatility are investigated. Realized volatility can be computed from returns observed over time intervals of different sizes. For simple statistical reasons, volatility estimators based on high-frequency returns have been proposed, but such estimators are found to be strongly biased as compared to volatilities of daily returns. This bias originates from microstructure effects in the price formation. For foreign exchange, the relevant microstructure effect is the incoherent price formation, which leads to a strong negative first-order autocorrelation ρ 1 40% for tick-by-tick returns and to the volatility bias. On the basis of a simple theoretical model for foreign exchange data, the incoherent term can be filtered away from the tick-by-tick price series. With filtered prices, the daily volatility can be estimated using the information contained in highfrequency data, providing a high-precision measure of volatility at any time interval.

Value‐at‐risk Trade‐off and Capital Allocation with Copulas

Abstract: This paper uses copula functions in order to evaluate tail probabilities and market risk trade-off sa t ag iven confidence level, dropping the joint normality assumption on returns. Copulas enable to represent distribution functions separating the marginal distributions from the association structure. We present an application to two stock market indices: for each market we recover the marginal probability distribution. We then calibrate copula functions and recover the joint distribution. The estimated copulas directly give the joint probabilities of extreme losses. Their level curves measure the trade-off between losses over different desks. This trade off can be exploited for capital allocation and is shown to depend on fat-tails.

Non parametric VaR Techniques. Myths and Realities

Abstract: VaR (value-at-risk) estimates are currently based on two main techniques: the variance-covariance approach or simulation. Statistical and computational problems affect the reliability of these techniques. We illustrate a new technique – filtered historical simulation (FHS) – designed to remedy some of the shortcomings of the simulation approach. We compare the estimates it produces with traditional bootstrapping estimates. (J.E.L.: G19).

Does Correlation Between Stock Returns Really Increase During Turbulent Periods

Abstract: Correlations betwen international equity markets are often claimed to increase during periods of high volatility. Therefore the benefits of international diversification are reduced when they are most needed, i.e. during turbulent periods. This paper investigates the relationship between international correlation and stock-market turbulence. We estimate a multivariate Markov-switching model, in which the correlation matrix varies across regimes. Subsequently, we test the null hypothesis that correlations are regime-independent. Using weekly stock returns for the S&P, the DAX and the FTSE over the period 1988–99, we find that international correlations significantly increased during turbulent periods. (J.E.L.: C53, G15).

Rating Agency Actions and the Pricing of Debt and Equity of European Banks: What Can we Infer About Private Sector Monitoring of Bank Soundness?

Abstract: The recent consultative papers by the Basel Committee on Banking Supervision has raised the possibility of an explicit role for external rating agencies in the assessment of the credit risk of banks’ assets, including interbank claims. Any judgement on the merits of this proposal calls for an assessment of the information contained in credit ratings and its relationship to other publicly available information on the financial health of banks and borrowers. We assess this issue via an event study of rating change announcements by leading international rating agencies, focusing on rating changes for European banks for which data on bond and equity prices are available. We find little evidence of announcement effects on bond prices, which may reflect the lack of liquidity in bond markets in Europe during much of our sample period. For equity prices, we find strong effects of ratings changes, although some of our results may suffer from contamination by contemporaneous news events. We also test for pre-announcement and post-announcement effects, but find little evidence of either. Overall, our results suggest that ratings agencies may perform a useful role in summarizing and obtaining non-public information on banks and that monitoring of banks’ risk through bond holders appears to be relatively limited in Europe. The relatively weak monitoring by bondholders casts some doubt on the effectiveness of a subordinated debt requirement as a supervisory tool in the European context, at least until bond markets are more developed. (J.E.L.: E53, G21, G33)

Fuzzy Value-at-risk: Accounting for Market Liquidity

Abstract: In this paper we present a value-at-risk measure which accounts for market liquidity. We show that taking into account market liquidity implies a decoupling of valuation of long and short positions. We present a pricing model, named fuzzy measure model, that yields different values for positions of different sign and that can be usefully exploited to account for liquidity risk. This methodology is well-suited to price options when the distribution of the underlying asset is not known precisely, as in the case of implied options in corporate claims or real options. As an example, we apply our pricing technique to an option based model of value-at-risk, in line with the Merton and Perold approach, and we recover different value-at-risk figures for long and short positions. (J.E.L.: C00, D81, G12).

Enforcing the 1988 Basel Capital Requirements: Did it Curtail Bank Credit in Emerging Economies?

Abstract: We examine whether the enforcement of bank capital asset requirements (CARs) curtailed the supply of credit in emerging economies. Preliminarily, we identify 16 emerging economies that – according to official and impartial reports – enforced the 1988 Basel standard during the 1990s. Then we perform our twofold econometric analysis. In the former part, we use macro data to test whether, controlling for economic fundamental variables, the enforcement brought about a slowdown in aggregate credit in these countries vis-a-vis other emerging economies. We find some support for our hypothesis. In the latter part, we employ individual bank data to better identify the ‘capital crunch’ effect of the enforcement. Here, we find that CAR enforcement – according to the 1988 Basel standard – significantly curtailed credit supply, particularly at less well-capitalized banks. The two empirical parts together suggest that the CAR enforcement did curtail aggregate credit in the examined emerging countries and that this result is rooted in the attempt by under-capitalized banks to reduce their loans. We argue that among developing countries – where banks are often the only source of financial intermediation – the positive effect of higher capital requirements, represented by the reduction of poor quality lending, may be offset by their negative impact on bank liquidity and on the level of economic activity. Hence, our results suggest that particular care is required to avoid potential negative macroeconomic effects when phasing in new and higher capital requirements in emerging economies. (J.E.L.: G18, G21, G28)

Credit Risk: Constructing the Basic Building Blocks

Abstract: This paper uses three basic results to address three problems. The first problem concerns the pricing of corporate bonds, when in the event of default the claim of the bond holders is on the principal of the bond plus accrued interest. The second concerns the pricing of revolver loans, and the third problem we address is the valuation of the collateral associated with a loan. (J.E.L.: G12, G13)

The Definition of the Grading Scales in Banks’ Internal Rating Systems

Abstract: An internal risk rating system can be defined as the process used to classify bank borrowers into categories of different credit riskiness. Most of the related literature has investigated various aspects of this process, but the problem of defining the categories and the distribution of borrowers into the different classes or grades has received rather less attention, other than noting that the number of grades and their dispersion should achieve a meaningful differentiation of risk. An appropriate definition of the grading scale is of primary importance because the probability of default associated to each grade is the key inputs of capital allocation systems at many best-practice banks and is the core of the January 2001’s new proposal of the Basel Committee for the calculation of capital requirements. Statistical techniques such as cluster analysis can help in identifying distinct subgroups of borrowers possessing the same creditworthiness. We use a logit model to estimate individual default probabilities for four categories of borrowers and apply cluster analysis to assign borrowers to each grade. However, since cluster analysis is not a purely mechanical process, but requires examination of the nature of observations and of the objective of clustering, the ultimate choice of the most appropriate grading scale for a given portfolio relies on empirical grounds. A sufficient granularity and an appropriate quantification of risk must be balanced. (J.E.L.: G21, G22, G33)

Current account and exchange rate dynamics

Abstract: The theoretical part of this paper analyses the positive and normative effects of a surprise monetary expansion in a small open economy characterized by imperfect competition and short-run price rigidity in the domestic sector The temporary output boom fostered by the monetary expansion is shown to come at the cost of a permanent squeeze of the domestic sector This affects welfare ambiguously, as the overall welfare consequences of the monetary expansion may eventually turn negative for a critical value of external assets The empirical part of the paper provides evidence in favour of a key role of monetary shocks in driving current account fluctuations in seven major industrialized countries (JEL: E61, F41)

Deterministic and Stochastic Methods for Estimation of Intra‐day Seasonal Components with High Frequency Data

Abstract: We introduce a model for the analysis of intra-day volatility based on unobserved components. The stochastic seasonal component is essential to model time-varing intra-day effects. The model is estimated with high frequency data for Deutsche mark–US dollar for 1993 and 1996. The model performs well in terms of coherence with the theoretical aggregation properties of GARCH models, it is effective in terms of both forecasting ability and describing reactions to macroeconomic news. (J.E.L.: C14, C53, F31).

Knightian Uncertainty in Financial Markets: An Assessment

Abstract: If information is too vague and imprecise to be summarized by a unique additive probability measure, an agent faces Knightian uncertainty or ambiguity rather than risk. Under Knightian uncertainty, an agent's beliefs may be represented by a capacity or a set of additive probabilities. It is proved that an agent's attitude towards ambiguity has a crucial role in asset price determination and portfolio choice. Knightian uncertainty attitude provides an alternative explanation of financial market failures and enables puzzles to be solved, such as market breakdowns, price indeterminacy and volatility, bid and ask spreads, portfolio inertia, violation of call and put parity. (J.E.L.: D81, G11, G12).

Measuring Monetary Policy Shocks in a Small Open Economy

Abstract: n this paper, we present different specifications of a structural vector autoregressive model (SVAR) that can be used to identify monetary policy operating regimes and monetary policy shocks in a small open economy. SVAR has the advantage of imposing a minimal set of theoretical restrictions on the model to be tested. A monetary policy shock is identified with the residual of an equation regressing a monetary policy instrument on a set of variables that are considered relevant for the decisions of the central bank. We focus on the Italian economy in the 90s and try to establish if monetary policy shocks are better identified using exchange rates or foreign exchange reserves as a conditioning variable for the small open economy framework. In the considered sample, we have two periods of quasi-fixed nominal exchange rates (1989.06 - 1992.09; 1996.11 - 1998.04) and one of free floating (1992.10 - 1996.10). Given the limited span of the subperiods and the monthly frequency of the data, we treat the whole sample as one of managed floating of the Lira and propose different model specifications to check whether the identification of the central bank operating regime and of the monetary policy shocks is robust enough. Our methodology is based on De Arcangelis and Di Giorgio (1998), which in turn extended to a small open economy the research strategy introduced by Strongin (1995) and further developed by Bernanke and Mihov (1998) for the US. More precisely, we give a structural content to the VAR models by linking econometric analysis with the institutional knowledge of how the market for banks reserves (i.e., the market in which monetary policy is actually conducted) works in Italy. In our estimated models, indeed, identification hinges on a detailed description of the operating procedures used by the Bank of Italy. The advantage of this procedure is that it allows for a direct test of different model alternatives that are nested in the same specification, without imposing one identification mechanism a priori. The correct measure of a monetary policy shock is then selected by the data itself. Our analysis confirms the view that the Bank of Italy has been targeting the rate on overnight interbank loans in the 90s. This result is obtained with either proposed modeling choices. Therefore, we interpret shocks to the overnight rate as purely exogenous monetary policy shocks and study how they impact the economy. In the model with the exchange rate, following a monetary policy restriction, output declines and shows a statistically significant reduction for about one year after 7-8 months. Although we have not included a commodity price index we find no evidence of a price puzzle. The model does not either exhibit any liquidity puzzle. The model with foreign reserves provide similar results with a more pronounced output response. Also the inclusion of a German interest rate (whose innovations could be interpreted as a proxy for foreign monetary policy shocks) does not modify the identification results and the qualitative responses of output and inflation.

Competition Among Banks, Capital Requirements and International Spillovers

Abstract: The design of prudential bank capital requirements interacts with the industrial organization of the banking sector, in particular, with the level of competition among banks. Increased competition leads to excessive risk-taking by banks which may have to be counteracted by tighter capital requirements. When capital requirements are internationally uniform but the levels of competition among banks in different countries are not, international spillovers arise on financial integration of these countries. This result begs a more careful analysis of the effect of financial liberalization on the stability of banking sectors in emerging countries. It also calls into question the merits of employing uniform capital requirements across countries that diverge in the industrial organization of their banking sectors. (J.E.L.: G21, G28, G38, F36, E58, D62)

Perverse Effects of an External Ratings‐Related Capital Adequacy System

Abstract: It has recently been proposed that banks should be allowed to hold less capital against loans to borrowers who have received a favourable rating by an approved external credit assessment institution (ECAI), or rating agency. But a plausible model of rating agency behaviour shows that this strategy could have perverse results, actually increasing the risk of deposit insurance outlays. First, there is an issue of signalling, whereby low-ability borrowers may alter their behaviour so as to secure a lower capital requirement for their borrowing. Second, the establishment of a regulatory cut-off may actually reduce the amount of risk information made available by raters. Besides, the credibility of rating agencies may not be damaged by neglect of the risk of unusual systemic shocks, though it is these that cause the major bank failure costs. (J.E.L.:E53, G21, G33)

Monetary Disequilibrium, Endogenous Money, Stability and the Determinacy of Inflation

Abstract: This paper examines the stability of the disequilibrium money model, with endogenous money and transitory interest rate control by the Central Bank. In the tradition of the post-Keynesian literature, the money supply is determined by bank lending and disequilibrium between money demand and supply determines the business cycle. The rate of interest is assumed to react to an inflation target and inflation responds to the business cycle. The paper examines the stability of the model under three inflation response systems: the accelerationist model, adaptive expectations and rational expectations.

The New Basel Capital Adequacy Framework

Abstract: The Basel Committee on Banking Supervision is about to publish a second consultative paper on the reform of the 1988 Accord on capital adequacy. The new document takes into account the comments received on the June 1999 consultative paper, gives a much clearer picture of crucial aspects of the reform that were only presented in very general terms in the earlier paper, and quantifies most of the parameters that will be needed to calculate the capital requirements. Although considerable progress has been made towards reaching operational status, several aspects of the regulation still need to be worked out and further reflection is needed on the best way to tackle some of the more problematic issues that have been identified. Comments, suggestions, criticisms such as today’s seminar will certainly provide, are therefore most welcome. There will be time to take them into consideration, as the final draft of the regulation will not be completed before the end of 2001. My presentation is divided into three parts: I first illustrate the objectives of the reform, then describe the essential features of the new regulation, and finally discuss the possible impacts of its implementation. (J.E.L. G21, G28).

Hedging a Portfolio of Derivative Securities: A Simulation Approach

Abstract: We illustrate a numerical simulation method to decompose a portfolio of derivative securities in a linear combination of dynamical risk factors. The price of the portfolio and its sensitivities are linear functions of these factors. The method generalizes the static hedging theory proposed by Madan and Milne (1994) and applies to a dynamically complete, arbitrage free market with purely Brownian fluctuating assets. The extension to a class of market models whose volatility dynamics shows long memory and scaling behaviour is discussed and shown to be possible. (J.E.L.: G12).

Analytical and Empirical Features of Internal Ratings: An Empirical Consistency Test based on Statistical Models

Abstract: Internal ratings represent an important input to the new generation of ‘credit portfolio models’ and to the new capital requirements proposed by the Basel Committee on Banking Supervision; however, their reliability must be validated. In this paper, we first recall the main theoretical and practical aspects explaining the relevance gained by internal ratings in the banks’ operating practices and in the current reform proposals on bank capital regulation. We then show how some statistical models can be used to evaluate a rating system when no great amount on past data is available. To this goal, we first set up a binomial model to capture the main drivers of a borrower’s default; then, we build a separate multinomial model to ‘clone’ the judgements issued by human experts. Finally, we compare the two models: the degree of consistency between them looks reasonable, but is far from being perfect. The main causes of these disagreements are analysed, and some improvements of the current rating process are proposed. (J.E.L. G290, C250)

Capital Requirements in a Financially Driven Business Cycle Model

Abstract: We consider a simple overlapping generations economy where, because of asymmetric information and limited liability both in the loan and the deposits markets, firms have the incentive to undertake less efficient investment projects, while intermediaries have the incentive to monitor a smaller number of firms. Because of the positive relationship between the deposit interest rate and the level of monitoring, the lending activity of intermediaries may cause endogenous fluctuations in the level of economic activity. In this economy, a higher capital requirement, introduced to render deposit contracts incentive compatible, implies a higher steady state stock of capital, fewer bankruptcies among intermediaries and smaller fluctuations in the level of economic activity. (J.E.L. E32, D82, G28)