Showing papers on "Credit risk published in 2002"

Default Risk in Equity Returns

Abstract: This is the first study that uses Merton's (1974) option pricing model to compute default measures for individual firms and assess the effect of default risk on equity returns. The size effect is a default effect, and this is also largely true for the book-to-market (BM) effect. Both exist only in segments of the market with high default risk. Default risk is systematic risk. The Fama-French (FF) factors SMB and HML contain some default-related information, but this is not the main reason that the FF model can explain the cross-section of equity returns.

Credit Risk in Two Institutional Regimes: Spanish Commercial and Savings Banks

Abstract: Although credit risk is an important factor that financial institutions must cope with, the determinants of bank problem loans have been little studied. Using panel data, we compare the determinants of problem loans of Spanish commercial and savings banks in the period 1985–1997, taking into account both macroeconomic and individual bank level variables. The GDP growth rate, firms, and family indebtedness, rapid past credit or branch expansion, inefficiency, portfolio composition, size, net interest margin, capital ratio, and market power are variables that explain credit risk. However, there are significant differences between commercial and savings banks, which confirm the relevance of the institutional form in the management of credit risk. Our findings raise important bank supervisory policy issues: the use of bank level variables as early warning indicators, the advantages of bank mergers from different regions, and the role of banking competition and ownership in determining credit risk.

Trade Credit: Suppliers as Debt Collectors and Insurance Providers

Abstract: There are two fundamental puzzles about trade credit: why does it appear to be so expensive, and why do input suppliers engage in the business of lending money? This paper addresses and answers both questions analysing the interaction between the financial and the industrial aspects of the supplier-customer relationship. It examines how, in a context of limited enforceability of contracts, suppliers may have a comparative advantage over banks in lending to their customers because they hold the extra threat of stopping the supply of intermediate goods. Suppliers may also act as liquidity providers, providing insurance against liquidity shocks that may endanger the survival of their customer relationships. The relatively high implicit interest rates of trade credit result from the existence of insurance and default premia. The implications of the model are examined empirically using parametric and nonparametric techniques on a panel of UK firms.

Structural Models of Corporate Bond Pricing: An Empirical Analysis

Abstract: This paper empirically tests five structural models of corporate bond pricing: Those of Merton (1974), Geske (1977), Leland and Toft (1996), Longstaff and Schwartz (1995), and Collin-Dufresne and Goldstein (2001). We implement the models using a sample of 182 bond prices from firms with simple capital structures during the period 1986-1997. The conventional wisdom is that structural models do not generate spreads as high as those seen in the bond market, and true to expectations we find that the predicted spreads in our implementation of the Merton model are too low. The compound option approach of Geske comes much closer to the spreads observed in the market, on average, but still underpredicts spreads. In contrast, the Leland and Toft model substantially overestimates credit risk on most bonds, and especially so for high coupon bonds. The Longstaff and Schwartz model modifies Merton to incorporate a stochastic interest rate and a correlation between interest rates and firm value. While the correlation and the level of interest rates have little effect, higher interest rate volatility leads to higher predicted spreads. However, this and other features of this model result in spreads that are often too high for risky bonds and too low for safe bonds. The target leverage ratio model of Collin-Dufresne and Goldstein helps to raise the spreads on the bonds that were considered very safe by the Longstaff and Schwartz model, but overall tends toward overestimation of credit risk. We conclude that structural models do not systematically underpredict spreads, as the previous literature implies, but accuracy is a problem. Moreover, some of the simplifications made to date lead to overestimation of credit risk on the riskier bonds while scarcely affecting the spreads of the safest bonds.

An Introduction to Credit Risk Modeling

Abstract: The Basics of Credit Risk Management Expected Loss Unexpected Loss Regulatory Capital and the Basel Initiative Modeling Correlated Defaults The Bernoulli Model The Poisson Model Bernoulli versus Poisson Mixture An Overview of Common Model Concepts One-Factor/Sector Models Loss Dependence by Means of Copula Functions Working Example on Asset Correlations Generating the Portfolio Loss Distribution Asset Value Models Introduction and a Brief Guide to the Literature A Few Words about Calls and Puts Merton's Asset Value Model Transforming Equity into Asset Values: A Working Approach The CreditRisk+ Model The Modeling Framework of CreditRisk+ Construction Step 1: Independent Obligors Construction Step 2: Sector Model Risk Measures and Capital Allocation Coherent Risk Measures and Expected Shortfall Contributory Capital Term Structure of Default Probability Survival Function and Hazard Rate Risk-Neutral vs. Actual Default Probabilities Term Structure Based on Historical Default Information Term Structure Based on Market Spreads Credit Derivatives Total Return Swaps Credit Default Products Basket Credit Derivatives Credit Spread Products Credit-Linked Notes Collateralized Debt Obligations Introduction to Collateralized Debt Obligations (CDOs) Different Roles of Banks in the CDO Market CDOs from the Modeling Point of View Multi-Period Credit Models Former Rating Agency Model: Moody's BET Developments, Model Issues, and Further Reading References Index

Information sharing, lending and defaults: Cross-country evidence

Abstract: Theory predicts that information sharing among lenders attenuates adverse selection and moral hazard, and can therefore increase lending and reduce default rates. Using a new, purpose-built data set on private credit bureaus and public credit registers, we find that bank lending is higher and credit risk is lower in countries where lenders share information, regardless of the private or public nature of the information sharing mechanism. We also find that public intervention is more likely where private arrangements have not arisen spontaneously and creditor rights are poorly protected.

Is there a liability of foreignness in global banking? An empirical test of banks' X‐efficiency

Abstract: When a company operates outside of its home country, it may suffer a ‘liability of foreignness.’ Does this a priori theoretical expectation hold in the global banking industry? Banks increasingly compete outside of their home countries, and operating environments often differ sharply across countries, both in terms of financial markets and credit risk. In this paper, we report the results of an empirical test of the liability of foreignness in the global banking industry, using Fitch–IBCA BankScope data for the period 1989–96. Our findings strongly support the liability of foreignness hypothesis. Further, the data show some evidence that the X-efficiency of a foreign-owned bank is strongly influenced by the competitiveness of its home country and the host country in which it operates. Lastly, we find that in some environments U.S.-owned banks are more X-efficient than other foreign-owned banks in some environments, but less X-efficient in others. Copyright © 2002 John Wiley & Sons, Ltd.

An Empirical Analysis of Personal Bankruptcy and Delinquency

Abstract: This article uses a new dataset of credit card accounts to analyze credit card delinquency, personal bankruptcy, and the stability of credit risk models. We estimate duration models for default and assess the relative importance of different variables in predicting default. We investigate how the propensity to default has changed over time, disentangling the two leading explanations for the recent increase in default rates—a deterioration in the risk composition of borrowers versus an increase in borrowers’ willingness to default due to declines in default costs. Even after controlling for risk composition and economic fundamentals, the propensity to default significantly increased between 1995 and 1997. Standard default models missed an important time-varying default factor, consistent with a decline in default costs. Debt issued by consumers is an understudied asset class. There has been particularly little academic study of recent trends in default on this debt. Between 1994 and 1997 the number of personal bankruptcy filings in the United States rose by about 75%. The 1.35 million filings in 1997 represented well over 1% of U.S. households. Delinquency rates on credit cards rose almost as sharply [Federal Reserve Bank of Cleveland (1998)]. The resulting losses to lenders amounted to a sizable fraction of the interest payments they collect, potentially raising the average cost of credit. These trends in default, both in bankruptcy and delinquency, are especially surprising in light of the strong economy over the period. They provide an unusually rich source of variation to test the stability of models that forecast personal default and of credit risk models more generally. There are two leading explanations for these trends. First, the risk composition of borrowers might have worsened. Under the “risk effect,” less

Ratings migration and the business cycle, with application to credit portfolio stress testing

Abstract: The turmoil in the capital markets in 1997 and 1998 has highlighted the need for systematic stress testing of banks' portfolios, including both their trading and lending books. We propose that underlying macroeconomic volatility is a key part of a useful conceptual framework for stress testing credit portfolios, and that credit migration matrices provide the specific linkages between underlying macroeconomic conditions and asset quality. Credit migration matrices, which characterize the expected changes in credit quality of obligors, are cardinal inputs to many applications, including portfolio risk assessment, modeling the term structure of credit risk premia, and pricing of credit derivatives. They are also an integral part of many of the credit portfolio models used by financial institutions. By separating the economy into two states or regimes, expansion and contraction, and conditioning the migration matrix on these states, we show that the loss distribution of credit portfolios can differ greatly, as can the concomitant level of economic capital to be assigned.

No Pain, No Gain? Effecting Market Discipline Via 'Reverse Convertible Debentures'

Abstract: The deadweight costs of financial distress limit many firms' incentive to include a lot of (tax-advantaged) debt in their capital structures. It is therefore puzzling that firms do not make advance arrangements to re-capitalize themselves if large losses occur. Financial distress may be particularly important for large banking firms, which national supervisors are reluctant to let fail. The supervisors' inclination to support large financial firms when they become troubled mitigates the ex ante incentives of market investors to discipline these firms. This paper proposes a new financial instrument that forestalls financial distress without distorting bank shareholders' risk-taking incentives. "Reverse convertible debentures" (RCD) would automatically convert to common equity if a bank's market capital ratio falls below some stated value. RCD provide a transparent mechanism for un-levering a firm if the need arises. Unlike conventional convertible bonds, RCD convert at the stock's current market price, which forces shareholders to bear the full cost of their risk-taking decisions. Surprisingly, RCD investors are exposed to very limited credit risk under plausible conditions.

Default, Currency Crises, and Sovereign Credit Ratings

Abstract: Sovereign credit ratings play an important part in determining countries' access to international capital markets and the terms of that access. In principle, there is no reason to expect that sovereign credit ratings should systematically predict currency crises. In practice, in emerging market economies there is a strong link between currency crises and default. Hence if credit ratings are forward-looking and currency crises in emerging market economies are linked to defaults, it follows that downgrades in credit ratings should systematically precede currency crises. This article presents results suggesting that sovereign credit ratings systematically fail to predict currency crises but do considerably better in predicting defaults. Downgrades in credit ratings usually follow currency crises, possibly suggesting that currency instability increases the risk of default.

Default, Currency Crises and Sovereign Credit Ratings

Abstract: Sovereign credit ratings play an important role in determining the terms and the extent to which countries have access to international capital markets. In principle, there is no reason why changes in sovereign credit ratings should be expected to systematically predict a currency crisis. In practice, however, in developing countries there is a strong link between currency crises and default. About 85 percent of all the defaults in the sample are linked with currency crises. The results presented here suggest that sovereign credit ratings systematically fail to anticipate currency crises--but do considerably better predicting defaults. Downgrades usually follow the currency crisis--possibly highlighting how currency instability increases default risk.

Optimal capital structure and endogenous default

Abstract: In a sequence of fascinating papers, Leland and Leland and Toft have investigated various properties of the debt and credit of a firm which keeps a constant profile of debt and chooses its bankruptcy level endogenously, to maximise the value of the equity. One feature of these papers is that the credit spreads tend to zero as the maturity tends to zero, and this is not a feature which is observed in practice. This defect of the modelling is related to the diffusion assumptions made in the papers referred to; in this paper, we take a model for the value of the firm's assets which allows for jumps, and find that the spreads do not go to zero as maturity goes to zero. The modelling is quite delicate, but it just works; analysis takes us a long way, and for the final steps we have to resort to numerical methods.

The Effect of Credit on Spending Decisions: The Role of the Credit Limit and Credibility

Abstract: The objective of the present research is to study consumer decisions to utilize a line of credit. The life-cycle hypothesis from economics argues that consumers should intertemporally reallocate their incomes over their life stream to maximize lifetime utility. One form of intertemporal allocation is to use past income (in the form of savings) in the future. A second form is the use of future income in the present. This can only be done if consumers have access to a temporary pool of money that they can draw from and replenish in the future--a function performed by consumer credit. However, our research reinforces prior findings that consumers are unable to correctly value their future incomes, and that they lack the cognitive capability to solve the intertemporal optimization problem required by the life-cycle hypothesis. Instead, we argue that consumers use information such as the credit limit as a signal of their future earnings potential. Specifically, if consumers have access to large amounts of credit, they are likely to infer that their lifetime income will be high and hence their willingness to use credit (and their spending) will also be high. Conversely, consumers who are granted lower amounts of credit are likely to infer that their lifetime income will be low and hence their spending will be lower.However, based on research in the area of consumer skepticism and inference making, we also argue for a moderating role of the credibility associated with the credit limit. Specifically, we argue that the above effect of credit availability would be particularly strong for consumers who believe that the credit limit credibly signals their future earnings potential (i.e., a naive consumer who has limited experience with consumer credit). However, as consumers gain experience with credit, they start discounting credit availability as a predictor of their future and start questioning the validity of the process used to set the credit limit. Hence, with experience the effect of credit limit on the willingness to use credit should be attenuated.We test these predictions in five separate studies. In the first experimental study, we manipulate credit limit and credibility and pose subjects with a hypothetical purchase opportunity. Consistent with our prediction, credit limit impacted the propensity to spend, but only when the credibility was high. In the second experimental study, we replicate these findings even when subjects were given information about their expected future salaries, and also show that the credit limit influences their expectation of future earnings potential. In the third study, we show that the mere availability (and increase) of current liquidity cannot explain our findings. In the fourth study, we conduct a survey of consumers in which we measure a number of demographic characteristics and also ask them for their propensity to spend in a given purchase situation. In the fifth study we use the Survey of Consumer Finances (SCF) dataset, a triennial survey of U.S. families that is designed to provide detailed information on the use of financial services, spending behaviors, and selected demographic characteristics. Results from both studies 4 and 5 provide further support for our proposed framework--credit limits influence spending to a greater extent for consumers with lower credibility: younger consumers and less-educated consumers. Across all studies we achieved triangulation by using a variety of approaches (surveys and experiments), subjects types (young students and older consumers), nature of predictor variables (manipulated and measured), dependent measures (purchase likelihood, credit card balance, new charges), and methods of analysis (ANOVA and regression), and consistently found that increasing credit limits on a credit card increases spending, especially when the credibility of the limit is high.This paper joins a growing body of literature in marketing and behavioral decision theory that goes beyond the traditional domains of inquiry (e.g., product choice, effects of marketing mix variables) and focuses on consumer decisions relating to the appropriate use of income to finance consumption. Our framework differs from prior research on the effect of payment mechanisms on spending in two significant ways. First, we are interested in the effects of the availability of credit on spending, and not necessarily in the effect of the transaction format that is associated with each payment mechanism. Second, while prior research has studied the point-of-purchase and historic (i.e., prepurchase) effects of credit, the present research is concerned with the availability of credit in the future. Specifically, our framework is invariant to the current and prior usage of credit by the consumer.

Estimating Bilateral Exposures in the German Interbank Market: Is There a Danger of Contagion?

Abstract: Credit risk associated with interbank lending may lead to domino effects, where the failure of one bank results in the failure of other banks not directly affected by the initial shock. Recent work in economic theory shows that this risk of contagion depends on the precise pattern of interbank linkages. We use balance sheet information to estimate the matrix of bilateral credit relationships for the German banking system and test whether the breakdownof a single bank can lead to contagion. We find that the financial safety net (institutional guarantees for saving banks and cooperative banks) considerably reduces - but does not eliminate - the danger of contagion. Even so, the failure of a single bank could lead to the breakdown of up to 15% of the banking system in terms of assets.

Commercial bank financial management in the financial-services industry

Abstract: I BANKING AND THE FORCES OF CHANGE IN THE FINANCIAL-SERVICES INDUSTRY 1 Overview of Banking and the Financial-Services Industry 2 Drivers of Change, Innovation, and Consolidation in the Financial-Services Industry 3 Technology in Banking: E-Money, E-Banking and E-Commerce II BANK FINANCIAL STATEMENTS, RISKS, AND VALUATION 4 Sources and Uses of Funds and the Risks of Banking 5 Accounting and Economic Models of Bank Performance and Valuation 6 Case Studies in Bank Valuation and Performance III THE BIG PICTURE: STRATEGIC PLANNING, RISK MANAGEMENT, AND THE MEASUREMENT OF BANK PERFORMANCE 7 Managing Value and Risk: Bank Corporate Strategy and Strategic Planning in the Financial-Services Industry 8 Risk Management: Asset-Liability Management and Interest-Rate Risk 9 Capital and Dividend Management: Theory Regulation and Practice IV CREDIT RISK: TRADITIONAL AND INNOCATIVE METHODS FOR MANAGING THE LENDING FUNCTION 10 The Traditional Approach to Business Lending: Theory and Practice 11 Modern Methods for Analyzing and Managing Credit 12 Consumer and Small Business Lending V THE LIQUIDITY, OPERATING, AND FOREIGN-EXCHANGE RISKS OF BANKING AND SECURITIZATION 13 Liquidity Risk and Liability Management 14 Net Noninterest Income ("Burden"), Operational Risk, Securitization, and Derivatives Activities 15 Globalization, International Banking, and Foreign-Exchange Risk VI THE ROLES OF REGULATION, DEPOSIT INSURANCE, AND ETHICS IN SHAPING BANKING AND THE FINANCIAL-SERVICES INDUSTRY 16 Theory Objectives, and Agencies of Risk Regulation 17 Deposit Insurance, Bank Failures, and the Savings-and-Loan Mess 18 Ethics in Banking and the Financial-Services Industry (FSI)

How good is the market at assessing bank fragility? A horse race between different indicators

Abstract: We explore for individual banks, active in the East Asian countries during the years 1996–1998, the performance of three sets of indicators of bank fragility that can be computed from publicly available information: accounting data, stock market prices, and credit ratings. We find significantly different patterns among the three groups of indicators both in their ability of forecasting financial distress at a specific point in time and over time. More specifically, in the South East Asia crisis episode the information based on stock prices or on judgmental assessments of credit rating agencies did not outpace backward looking information contained in balance sheet data. Stock market based information, though, has responded more quickly to changing financial conditions than ratings of credit risk agencies. Overall, the evidence supports the policy conclusion that, where the information processing is quite costly, as in most developing countries, it is important to use simultaneously a plurality of indicators to assess bank fragility.

Credit risk measurement and procyclicality

Abstract: This paper examines the two-way linkages between credit risk measurement and the macroeconomy. It first discusses the issue of whether credit risk is low or high in economic booms. It then reviews how macroeconomic considerations are incorporated into credit risk models and the risk measurement approach that underlies the New Basel Capital Accord. Finally, it asks what effect these measurement approaches are likely to have on the macroeconomy, particularly through their role in influencing the level of bank capital. The paper argues that much remains to be done in integrating macroeconomic considerations into risk measurement, particularly during the upswing of business cycles that are characterised by rapid increases in credit and asset prices. It also suggests that a system of risk-based capital requirements is likely to deliver large changes in minimum requirements over the business cycle, particularly if risk measurement is based on market prices. This has the potential to increase the financial amplification of business cycles, although other aspects of risk-based capital requirements are likely to work in the other direction. Further work on evaluating the net effects is important for both supervisory and monetary authorities.

Life Insurance Liabilities at Market Value: An Analysis of Insolvency Risk, Bonus Policy, and Regulatory Intervention Rules in a Barrier Option Framework

Abstract: This article takes a contingent claim approach to the market valuation of equity and liabilities in life insurance companies. A model is presented that explicitly takes into account the following: (i) the holders of life insurance contracts (LICs) have the first claim on the company's assets, whereas equity holders have limited liability; (ii) interest rate guarantees are common elements of LICs; and (iii) LICs according to the so-called contribution principle are entitled to receive a fair share of any investment surplus. Furthermore, a regulatory mechanism in the form of an intervention rule is built into the model. This mechanism is shown to significantly reduce the insolvency risk of the issued contracts, and it implies that the various claims on the company's assets become more exotic and obtain barrier option properties. Closed valuation formulas are nevertheless derived. Finally, some representative numerical examples illustrate how the model can be used to establish the set of initially fair contracts and to determine the market values of contracts after their inception. INTRODUCTION The subject of fair valuation of life insurance liabilities has attracted a lot of attention in the insurance and finance literature in recent years. This is caused by the product structure of the life insurance business as well as certain events in the financial markets. The late 1980s through the 1990s was a period of quite some turmoil for the life insurance business, and Europe, Japan, and the United States can all present their own spectacularly long lists of defaulted life insurance companies. Many of these were relatively small, but some massive defaults of large economic significance also occurred including the United States' First Executive Corporation ($19 billion in assets), France's Garantie Mutuelle des Functionnaires (see Briys and de Varenne, 1994), and Nissan Mutual Life of Japan, which went bankrupt with uncovered liabilities of $2.56 billion (see Grosen and Jorgensen, 2000). In retrospective discussions of the reasons for these unfortunate events, three issues appear repeatedly. The first is the mismanagement of the interest rate guarantees issued with most life insurance policies. The second is the mismanagement of credit risk stemming from either side of the balance sheet, and the third relates to the application of poor or inappropriate accounting principles, which in many cases have critically delayed or suppressed potentially useful warning signs in relation to company solvency. These issues are, of course, closely interrelated, as will be further clarified in the subsequent discussion. The focus on the interest rate guarantee relates to the fact that most policies contain an explicit guarantee that the holder's account will be credited--on a year-to-year basis--with a rate of return (the policy interest rate) of at least some fixed guaranteed rate, say, 5 percent. At the time of issuance, the guaranteed interest rate has typically been (much) lower than prevailing market interest rates, a fact that has led companies to ignore their value (as well as their risk), and, to the best of the authors' knowledge, premiums for these issued guarantees (read: liabilities) have not been demanded anywhere before 1999. (1) However, as a result of a period when market interest rates have generally been declining and when guaranteed interest rates have been held fixed, the companies have experienced a dramatic narrowing in the safety margin between the earning power of their assets and the claims from issued liabilities. This particular development is a major source of the problems of some life insurance c ompanies, although it is also a bit ironic, because the fundamental function of insurance companies in general is to provide a guaranty of asset value to the customer, as pointed out by, e.g., Merton and Bodie (1992). Interest rate guarantees are thus a source of credit risk arising from the liability side of the balance sheet. …

The estimation of transition matrices for sovereign credit ratings

Abstract: Rating transition matrices for sovereigns are an important input to risk management of portfolios of emerging market credit exposures. They are widely used both in credit portfolio management and to calculate future loss distributions for pricing purposes. However, few sovereigns and almost no low credit quality sovereigns have ratings histories longer than a decade, so estimating such matrices is difficult. This paper shows how one may combine information from sovereign defaults observed over a longer period and a broader set of countries to derive estimates of sovereign transition matrices.

A survey of cyclical effects in credit risk measurement model

Abstract: We survey both academic and proprietary models to examine how macroeconomic and systematic risk effects are incorporated into measures of credit risk exposure. Many models consider the correlation between the probability of default (PD) and cyclical factors. Few models adjust loss rates (loss given default) to reflect cyclical effects. We find that the possibility of systematic correlation between PD and LGD is also neglected in currently available models.

The Paradox of Credit Ratings

Abstract: Credit ratings pose an interesting paradox. On one hand, credit ratings are enormously valuable and important. Rating agencies have great market influence and even greater market capitalization. Credit rating changes are major news; 2 rating agencies play a major role in every sector of the fixed income market. Credit ratings purport to provide investors with valuable information they need to make informed decisions about purchasing or selling bonds, and credit rating agencies seem to have impressive reputations. The market value of credit ratings was confirmed on September 30, 2000, when Moody’s Corp. became a free-standing publicly-traded entity. The market capitalization of Moody's as of April 2002 was more than $6 billion.

Sovereign Defaults the Role of Volatility

Abstract: While the relationship between volatility and credit risk is central to much of the literature on finance and banking, it has been largely neglected in empirical macro studies on sovereign defaults. This paper presents new econometric estimates for a panel of 25 emerging market countries over 1970-2001, breaking down aggregate volatility into its external and domestic policy components. We find that countries with historically higher macroeconomic volatility are more prone to default, and particularly so if part of this volatility is policy-induced. Reducing policy volatility thus appears to be key to improving a country`s credit standing.

The credit risk in SME loans portfolios: Modeling issues, pricing, and capital requirements

Abstract: This paper is devoted to the credit risk modeling issues of small commercial loans portfolios. We propose specific solutions dealing with the most important peculiarities of these portfolios: their large size and the limited information about the financial situation of borrowers. We then compute the probability density function of futures losses and VaR measures in a portfolio of 220.000 French SMEs. We also compute marginal risk contributions in order to discuss the loan pricing issue of small commercial loans and to compare the capital requirements derived from our model with those derived from the New Ratings-Based Basel Capital Accord.

Understanding the Determinants of Government Debt Ratings: Evidence for the Two Leading Agencies

Abstract: I conduct an analysis of the possible determinants of sovereign credit ratings assigned by the two leading credit rating agencies, Moody's and Standard and Poor's, by using both a linear and a logistic transformation of the rating scales. Of the large number of variables that can be used, the set of explanatory variables selected in this study is significant in explaining the credit ratings. Namely, six variables appear to be the most relevant to determine a country's credit rating: GDP per capita, external debt, level of economic development, default history, real growth rate and inflation rate.

Liquidity and Credit Risk

Abstract: We develop a structural bond valuation model to simultaneously capture liquidity and credit risk. Our model implies that renegotiation in financial distress is influenced by the illiquidity of the market for distressed debt. As default becomes more likely, the components of bond yield spreads attributable to illiquidity increase. When we consider finite maturity debt, we find decreasing and convex term structures of liquidity spreads. Using bond price data spanning 15 years, we find evidence of a positive correlation between the illiquidity and default components of yield spreads as well as support for downward sloping term structures of liquidity spreads.

Credit risk and efficiency in the European banking system: A three-stage analysis

Abstract: Increased competition and the attempts of European banks to increase their presence in other markets may have affected the efficiency and credit risk in the banking system. The first aspect is the incentive in reducing costs in order to gain in competitiveness. The second is associated with their lack of knowledge of such markets and/ or acceptance of a higher risk in order to increase their market share. Despite the importance of these aspects, banking literature has usually analysed the effects of competition on the efficiency of banking systems without considering these aspects. The few studies that attempt to obtain risk adjusted efficiency measures do not consider that part of the risk is due to exogeneous circumstances. This article proposes a new three-stage sequential technique, based on the DEA model and on the decomposition of risk into its internal and external components, for obtaining efficiency measures adjusted for risk and environment. It is seen that the technique allows the use of any ex...

Pricing default-risky cat bonds with moral hazard and basis risk

Abstract: This article develops a contingent claim model to price a default-risky, catastrophe-linked bond. This model incorporates stochastic interest rates and more generic loss processes and allows for practical considerations of moral hazard, basis risk, and default risk. The authors compute default-free and default-risky CAT bond prices by using the Monte Carlo method. The results show that both moral hazard and basis risk drive down the bond prices substantially; these effects should not be ignored in pricing the CAT bonds. The authors also show how the bond prices are related to catastrophe occurrence intensity, loss volatility, trigger level, the issuing firm's capital position, debt structure, and interest rate uncertainty. INTRODUCTION Property-liability insurance companies traditionally hedge their low-loss frequency, high-loss-severity catastrophe risks by buying catastrophe reinsurance contracts. The traditional reinsurance and catastrophe insurance options, which trade in the Chicago Board of Trade (CBOT), are asset hedge instruments for insurers' or reinsurers' catastrophe risk management. A recent innovation in catastrophe risk management is the catastrophe bond (CAT bond, hereafter). The CAT bond, which is also named as an "Act of God bond" or "insurance-linked bond," is a liability hedge instrument for insurance companies, for which there have been many successful CAT bond issues recently. (1) CAT bond provisions have debt-forgiveness triggers whose generic design allows for the payment of interest and/or the return of principal forgiveness, and the extent of forgiveness can be total, partial, or scaled to the size of loss. Moreover, the debt forgiveness can be triggered by the insurer's (or reinsurer's) actual losses or on a compos ite index of insurers' losses during a specific period. The advantage of a CAT bond hedge for (re)insurers (insurers, hereafter) is that the issuer can avoid the credit risk that may arise with traditional reinsurance or catastrophe-linked options. The CAT bondholders provide the hedge to the insurer by forgiving existing debt. Thus, the value of this hedge is independent of the bondholders' assets, and the issuer has no risk of nondelivery on the hedge. However, from the bondholder's perspective, the default risk, the potential moral hazard behavior, and the basis risk of the issuing firm are critical in determining the value of CAT bonds. The moral hazard behavior occurs when the insurer's cost of loss control efforts exceeds the benefits from debt forgiveness. That is, the insurer has an incentive to pay the claims more generously when the loss amount is near the trigger set in the debt-forgiveness provision. Doherty (1997) pointed out that moral hazard results from less loss control efforts by the insurer issuing CAT bonds because these efforts will increase the amount of debt that must be repaid. Bantwal and Kunreuther (1999) also noted the tendency for insurers to write additional policies in a catastrophe-prone area, spending less time and money in their auditing of losses after a disaster. The moral hazard behavior may increase the claim payments at the expense of the bondholders' coupon (or principal) reduction and affect the bond price. Another important element that needs to be considered in pricing a CAT bond is the basis risk. The CAT bond's basis risk refers to the gap between the insurer's actual loss and the composite index of losses that prevents the insurer from receiving complete risk hedging. The basis risk may cause insurers to default on their debt in the case of high individual loss but low index of loss, and therefore affects the bond price. A tradeoff indeed exists between basis risk and moral hazard. If one uses an independently calculated index to define the CAT bond payments, then the insurer's opportunity to cheat the bondholders is reduced or eliminated, but basis risk is created. Doherty (1997) and Belonsky (1998), among others, have looked into the effect of basis risk and moral hazard, but not from the perspective of bond pricing. …