Showing papers on "Credit risk published in 2007"

Market liquidity and funding liquidity

Abstract: We provide a model that links an asset's market liquidity - i.e., the ease with which it is traded - and traders' funding liquidity - i.e., the ease with which they can obtain funding. Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and the margins they are charged, depend on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to “flight to quality¶, and (v) comoves with the market, and it provides new testable predictions. Keywords: Liquidity Risk Management, Liquidity, Liquidation, Systemic Risk, Leverage, Margins, Haircuts, Value-at-Risk, Counterparty Credit Risk

How Sovereign is Sovereign Credit Risk

Abstract: We study the nature of sovereign credit risk using an extensive sample of CDS spreads for 26 developed and emerging-market countries. Sovereign credit spreads are surprisingly highly correlated, with just three principal components accounting for more than 50 percent of their variation. Sovereign credit spreads are generally more related to the U.S. stock and high-yield bond markets, global risk premia, and capital flows than they are to their own local economic measures. We find that the excess returns from investing in sovereign credit are largely compensation for bearing global risk, and that there is little or no country-specific credit risk premium. A significant amount of the variation in sovereign credit returns can be forecast using U.S. equity, volatility, and bond market risk premia.

Optimal long-term financial contracting

Abstract: We develop an agency model of financial contracting. We derive long-term debt, a line of credit, and equity as optimal securities, capturing the debt coupon and maturity; the interest rate and limits on the credit line; inside versus outside equity; dividend policy; and capital structure dynamics. The optimal debt-equity ratio is history dependent, but debt and credit line terms are independent of the amount financed and, in some cases, the severity of the agency problem. In our model, the agent can divert cash flows; we also consider settings in which the agent undertakes hidden effort, or can control cash flow risk.

The Response of Corporate Financing and Investment to Changes in the Supply of Credit

Abstract: We examine how shocks to the supply of credit impact corporate financing and investment using the collapse of Drexel Burnham Lambert, Inc., the passage of the Financial Institutions Reform, Recovery, and Enforcement Act, and regulatory changes in the insurance industry as an exogenous contraction in the supply of below-investment-grade credit after 1989. A difference-in-differences empirical strategy coupled with a variety of treatment-control comparisons reveals that substitution to bank debt and alternative sources of capital (e.g., equity, cash balances, trade credit) was extremely limited. Consequently, net investment decreased almost one-for-one with the contraction in net issuing activity. Further, the impact of the credit contraction on financing and investment varied cross-sectionally as a function of geographic heterogeneity in the cost of bank capital and the credit risk of borrowers. Despite this sharp change in behavior, corporate leverage ratios remained relatively stable, a result of the contemporaneous decline in debt issuances and investment. Overall, our findings highlight how even large firms with access to public credit markets are susceptible to fluctuations in the supply of capital.

Determinants of Sovereign Risk: Macroeconomic Fundamentals and the Pricing of Sovereign Debt

Abstract: This paper investigates the effects of macroeconomic fundamentals on emerging market sovereign credit spreads. We find that the volatility of terms of trade in particular has a statistically and economically significant effect on spreads. This is robust to instrumenting terms of trade with a country-specific commodity price index. Our measures of country fundamentals have substantial explanatory power, even controlling for global factors and credit ratings. We also estimate default probabilities in a hazard model and find that model implied spreads capture a significant part of the variation in observed spreads out-of-sample. The fit is better for lower credit quality borrowers.

Modelling Credit Risk for SMEs: Evidence from the U.S. Market

Abstract: Considering the fundamental role played by small and medium sized enterprises (SMEs) in the economy of many countries and the considerable attention placed on SMEs in the new Basel Capital Accord, we develop a distress prediction model specifically for the SME sector and to analyse its effectiveness compared to a generic corporate model. The behaviour of financial measures for SMEs is analysed and the most significant variables in predicting the entities’ credit worthiness are selected in order to construct a default prediction model. Using a logit regression technique on panel data of over 2,000 U.S. firms (with sales less than $65 million) over the period 1994–2002, we develop a one-year default prediction model. This model has an out-of-sample prediction power which is almost 30 per cent higher than a generic corporate model. An associated objective is to observe our model's ability to lower bank capital requirements considering the new Basel Capital Accord's rules for SMEs.

The Credit Scoring Toolkit: Theory and Practice for Retail Credit Risk Management and Decision Automation

Abstract: The Credit Scoring Toolkit provides an all-encompassing view of the use of statistical models to assess retail credit risk and provide automated decisions. In eight modules, the book provides frameworks for both theory and practice. It first explores the economic justification and history of Credit Scoring, risk linkages and decision science, statistical and mathematical tools, the assessment of business enterprises, and regulatory issues ranging from data privacy to Basel II. It then provides a practical how-to-guide for scorecard development, including data collection, scorecard implementation, and use within the credit risk management cycle. Including numerous real-life examples and an extensive glossary and bibliography, the text assumes little prior knowledge making it an indispensable desktop reference for graduate students in statistics, business, economics and finance, MBA students, credit risk and financial practitioners.

Credit Risk Modeling

Abstract: The chapter gives a broad outline of the central themes of credit risk modeling starting with the modeling of default probabilities, ratings and recovery.We present the two main frameworks for pricing credit risky instruments and credit derivatives. The key credit derivative - the Credit Default Swap - is introduced. The premium on this contract provides a meausure of the credit spread of the reference issuer. We then provide some key empirical works looking at credit spreads thorugh CDS contracts and bonds and finish with a description of the role of correlation in credit risk modeling.

Sovereign Risk and Secondary Markets

Abstract: Conventional wisdom says that, in the absence of sufficient default penalties, sovereign risk constraints credit and lowers welfare We show that this conventional wisdom rests on one implicit assumption: that assets cannot be retraded in secondary markets Once this assumption is relaxed, there is always an equilibrium in which sovereign risk is stripped of its conventional effects In such an equilibrium, foreigners hold domestic debts and resell them to domestic residents before enforcement In the presence of (even arbitrarily small) default penalties, this equilibrium is shown to be unique As a result, sovereign risk neither constrains welfare nor lowers credit At most, it creates some additional trade in secondary markets The results presented here suggest a change in perspective regarding the origins of sovereign risk and its remedies To argue that sovereign risk constrains credit, one must show both the insufficiency of default penalties and the imperfect workings of secondary markets To relax credit constraints created by sovereign risk, one can either increase default penalties or improve the workings of secondary markets

Corporate credit risk modeling and the macroeconomy

Abstract: Despite a surge in the research efforts put into modeling credit and default risk during the past decade, few studies have incorporated the impact that macroeconomic conditions have on business defaults. In this paper, we estimate a duration model to explain the survival time to default for borrowers in the business loan portfolio of a major Swedish bank over the period 1994–2000. The model takes both firm-specific characteristics, such as accounting ratios and payment behaviour, loan-related information, and the prevailing macroeconomic conditions into account. The output gap, the yield curve and consumers’ expectations of future economic development have significant explanatory power for the default risk of firms. We also compare our model with a frequently used model of firm default risk that conditions only on firm-specific information. The comparison shows that while the latter model can make a reasonably accurate ranking of firms’ according to default risk, our model, by taking macro conditions into account, is also able to account for the absolute level of risk.

Governance Mechanisms and Bond Prices

Abstract: We investigate the effects of shareholder governance mechanisms on bondholders and document two new findings. First, the impact of shareholder control (proxied by large institutional blockholders) on credit risk depends on takeover vulnerability. Shareholder control is associated with higher (lower) yields if the firm is exposed to (protected from) takeovers. In the presence of shareholder control, the difference in bond yields due to differences in takeover vulnerability can be as high as 66 basis points. Second, event risk covenants reduce the credit risk associated with strong shareholder governance. Therefore, without bond covenants, shareholder governance, and bondholder interests diverge. , Oxford University Press.

Accounting-Based Versus Market-Based Cross-Sectional Models of CDS Spreads

Abstract: The relevance of accounting data to providers of capital has been strongly debated. In this paper we provide compelling evidence that accounting metrics are important to providers of debt capital. Models of firm distress are mostly either purely accounting-based (e.g. Altman, 1968; Ohlson, 1980) or purely market-based (e.g. Merton, 1974). We examine the information content of accounting-based and market-based metrics in pricing firm distress using a sample of Credit Default Swap (CDS) spreads. Credit Default Swaps are derivatives that offer protection from the event a given firm defaults on its obligations. CDS spreads provide a clean measure of default risk as they are the compensation that market participants require for bearing that risk. Using a sample of 2,860 quarterly CDS spreads available over the period 2001-2005 we find that a model of distress which is entirely composed of accounting-based metrics performs comparably, if not better, than market-based structural models of default. Furthermore, we find that both sources of information (accounting- and market-based) are complementary in pricing distress. These results support the notion that accounting metrics have direct value- or valuation-relevance to debt holders and holders of credit derivatives.

The Credit Scoring Toolkit: Theory and Practice for Retail Credit Risk Management and Decision Automation

Abstract: The Credit Scoring Toolkit provides an all-encompassing view of the use of statistical models to assess retail credit risk and provide automated decisions In eight modules, the book provides frameworks for both theory and practice It first explores the economic justification and history of Credit Scoring, risk linkages and decision science, statistical and mathematical tools, the assessment of business enterprises, and regulatory issues ranging from data privacy to Basel II It then provides a practical how-to-guide for scorecard development, including data collection, scorecard implementation, and use within the credit risk management cycle Including numerous real-life examples and an extensive glossary and bibliography, the text assumes little prior knowledge making it an indispensable desktop reference for graduate students in statistics, business, economics and finance, MBA students, credit risk and financial practitioners

Liquidity or Credit Risk? The Determinants of Very Short-Term Corporate Yield Spreads

Abstract: Employing a comprehensive database on transactions of commercial paper issued by domestic U.S. nonfinancial corporations, we study the determinants of very short-term corporate yield spreads. We find that liquidity plays a role in the determination of spreads but, somewhat surprisingly, credit quality is the more important determinant of spreads, even at horizons of less than 1 month. These results are robust across a variety of proxies for liquidity and credit risk, and have important implications for the literature on the modeling of corporate bond prices.

Trade Credit Defaults and Liquidity Provision by Firms

Abstract: Using a unique data set on trade credit defaults among French firms, we investigate whether and how trade credit is used to relax financial constraints. We show that firms that face idiosyncratic liquidity shocks are more likely to default on trade credit, especially when the shocks are unexpected, firms have little liquidity, are likely to be credit constrained or are close to their debt capacity. We estimate that credit constrained firms pass more than one fourth of the liquidity shocks they face on to their suppliers down the trade credit chain. The evidence is consistent with the idea that firms provide liquidity insurance to each other and that this mechanism is able to alleviate the consequences of credit constraints. In addition, we show that the chain of defaults stops when it reaches firms that are large, liquid, and have access to financial markets. This suggests that liquidity is allocated from large firms with access to outside finance to small, credit constrained firms through trade credit chains.

Understanding Changes in Corporate Credit Spreads

Abstract: New evidence is reported on the empirical success of structural models in explaining changes in corporate credit risk. A parsimonious set of common factors and company-level fundamentals, inspired by structural models, was found to explain more than 54 percent (67 percent) of the variation in credit-spread changes for medium-grade (low-grade) bonds. No dominant latent factor was present in the unexplained variation. Although this set of factors had lower explanatory power among high-grade bonds, it did capture most of the systematic variation in credit-spread changes in that category. It also subsumed the explanatory power of the Fama and French factors among all grade classes.

Contingent Claims Approach to Measuring and Managing Sovereign Credit Risk

Abstract: This paper proposes a new approach to measure, analyze, and manage sovereign risk based on the theory and practice of modern contingent claims analysis (CCA). The paper provides a new framework for adapting the CCA model to the sovereign balance sheet in a way that can help forecast credit spreads and evaluate the impact of market risks and risks transferred from other sectors. This new framework is useful for assessing vulnerability, policy analysis, sovereign credit risk analysis, and design of sovereign risk mitigation and control strategies. Applications for investors in three areas are discussed. First, CCA provides a new framework for valuing, investing, and trading sovereign securities, including sovereign capital structure arbitrage. Second, it provides a new framework for analysis and management of sovereign wealth funds being created by many emerging market and resource rich countries. Third, the framework provides quantitative measures of sovereign risk exposures which facilitates the design of new instruments and contracts to control or transfer sovereign risk.

‘Lending by numbers’: credit scoring and the constitution of risk within American consumer credit

Abstract: This paper examines how statistical credit-scoring technologies, sanctioned by the state in the interests of promoting equality, became applied by lenders to the problem of controlling levels of default within American consumer credit. However, these technologies, constituting consumers as ‘risks’, are themselves seen to be problematic, subject to their own conceived sets of methodological, procedural and temporal risks. Nevertheless, as this article will show, such technologies have increasingly been applied to other areas of consumer lending, thus interpreting a wider array of operational contingencies in terms of risk. Finally, it is argued that, since the 1980s, the constitution of credit consumers as risks has been deployed to new ends through technologies of ‘profit scoring’ and new practices of ‘risk pricing’.

Determinants of Credit Risk in Indian State- owned Banks: An Empirical Investigation

Abstract: The determinants of credit risk of banks in emerging economies have received limited attention in the literature. Using advanced panel data techniques, the paper seeks to examine the factors affecting problem loans of Indian state-owned banks for the period 1994-2005, taking into account both macroeconomic factors as well as microeconomic variables. The findings reveal that at the macro level, GDP growth and at the bank level, real loan growth, operating expenses and bank size play an important role in influencing problem loans. The study performs certain robustness tests of the results and discusses several policy implications of the analysis.

The Dynamic Pricing of Sovereign Risk in Emerging Markets: Fundamentals and Risk Aversion

Abstract: This paper introduces a new approach to pricing sovereign risk based on sovereign credit default swap (CDS) spreads. We estimate a dynamic market-based measure of sovereign risk and use it to decompose sovereign CDS spreads into expected losses from default and the market risk premia required by investors as compensation for default risk. Using a dynamic panel data model, we find that country-specific fundamentals primarily drive sovereign risk whilst global investors' risk aversion drives time variation in the risk premia. Consistent with this, we also find that the sovereign risk premia is more highly correlated than sovereign risk itself within emerging market regions. These results help us to explain the remarkable narrowing of emerging market spreads between 2002 and 2006 and to understand the pricing mechanism and channel of contagion for emerging debt markets.

Hazardous Times for Monetary Policy: What Do Twenty-Three Million Bank Loans Say about the Effects of Monetary Policy on Credit Risk-Taking?

Abstract: We investigate the impact of the stance and path of monetary policy on the level of credit risk of individual bank loans and on lending standards. We employ the Credit Register of the Bank of Spain that contains detailed monthly information on virtually all loans granted by all credit institutions operating in Spain during the last twenty-two years - generating almost twenty-three million bank loan records in total. Spanish monetary conditions were exogenously determined during the entire sample period. Using a variety of duration models we find that lower short-term interest rates prior to loan origination result in banks granting more risky new loans. Banks also soften their lending standards - they lend more to borrowers with a bad credit history and with high uncertainty. Lower interest rates, by contrast, reduce the credit risk of outstanding loans. Loan credit risk is maximized when both interest rates are very low prior to loan origination and interest rates are very high over the life of the loan. Our results suggest that low interest rates increase bank risk-taking, reduce credit risk in banks in the very short run but worsen it in the medium run. Risk-taking is not equal for all type of banks: Small banks, banks with fewer lending opportunities, banks with less sophisticated depositors, and savings or cooperative banks take on more extra risk than other banks when interest rates are lower. Higher GDP growth reduces credit risk on both new and outstanding loans, in stark contrast to the differential effects of monetary policy.

Sovereign Credit Ratings

Abstract: Sovereign ratings are gaining importance as more governments with greater default risk borrow in international bond markets. But while the ratings have proved useful to governments seeking market access, the difficulty of assessing sovereign risk has led to agency disagreements and public controversy over specific rating assignments. Recognizing this difficulty, the financial markets have shown some skepticism toward sovereign ratings when pricing issues.

Systemic Risk and Regulation

Abstract: Historically, much of the banking regulation that was put in place was designed to reduce systemic risk. In many countries capital regulation in the form of the Basel agreements is currently one of the most important measures to reduce systemic risk. In recent years there has been considerable growth in the transfer of credit risk across and between sectors of the …nancial system. In particular there is evidence that risk has been transfered from the banking sector to the insurance sector. One argument is that this is desirable and simply re‡ects diversi…cation opportunities. Another is that it represents regulatory arbitrage and the concentration of risk that may result from this could increase systemic risk. This paper shows that both scenarios are possible depending on whether markets and contracts are complete or incomplete.

Access to Institutional Finance and the Use of Trade Credit

Abstract: I develop a conceptual framework for analyzing the effect of the availability of institutional loans on firms' demand for supplier (trade) finance. I test for the existence of credit constraints and their effect on corporate financing policies. My empirical results support the hypothesis that trade credit is taken up by firms as a substitute for institutional finance at the margin when they are credit constrained. Further, in line with studies on the credit channel of monetary policy transmission, I find an increased reliance on trade credit by financially constrained firms during periods of tight money.

Financial Risk Management for Islamic Banking and Finance

Abstract: Principles of Islamic Finance Risk Management Issues in Islamic Financial Contracts Basel II& IFSB for Islamic Financial Risk Market Risk in Islamic Finance Credit Risk in Islamic Finance Operational Risk in Islamic Finance Concluding Remarks