Showing papers on "Credit risk published in 2008"
Posted Content•
TL;DR: This paper developed a small open economy model to study default risk and its interaction with output, consumption, and foreign debt, which predicts that default incentives and interest rates are higher in recessions, as observed in the data.
Abstract: Recent sovereign defaults in emerging countries are accompanied by interest rate spikes and deep recessions. This paper develops a small open economy model to study default risk and its interaction with output, consumption, and foreign debt. Default probabilities and interest rates depend on incentives for repayment. Default occurs in equilibrium because asset markets are incomplete. The model predicts that default incentives and interest rates are higher in recessions, as observed in the data. The reason is that in a recession, a risk averse borrower finds it more costly to repay non-contingent debt and is more likely to default. In a quantitative exercise the model matches various features of the business cycle in Argentina such as: high volatility of interest rates, higher volatility of consumption relative to output, a negative correlation of interest rates and output and a negative correlation of the trade balance and output. The model can also predict the recent default episode in Argentina.
938 citations
TL;DR: Pan et al. as discussed by the authors explored the nature of default arrival and recovery implicit in the term structures of sovereign CDS spreads, and showed that a single-factor model with λ Q following a lognormal process captures most of the variation in the terms of spreads.
Abstract: This paper explores the nature of default arrival and recovery implicit in the term structures of sovereign CDS spreads. We argue that term structures of spreads reveal not only the arrival rates of credit events (λ Q ), but also the loss rates given credit events. Applying our framework to Mexico, Turkey, and Korea, we show that a single-factor model with λ Q following a lognormal process captures most of the variation in the term structures of spreads. The risk premiums associated with unpredictable variation in λ Q are found to be economically significant and co-vary importantly with several economic measures of global event risk, financial market volatility, and macroeconomic policy. THE BURGEONING MARKET FOR SOVEREIGN CREDIT DEFAULT SWAPS (CDS) contracts offers a nearly unique window for viewing investors’ risk-neutral probabilities of major credit events impinging on sovereign issuers, and their risk-neutral losses of principal in the event of a restructuring or repudiation of external debts. In contrast to many “emerging market” sovereign bonds, sovereign CDS contracts are designed without complex guarantees or embedded options. Trading activity in the CDS contracts of several sovereign issuers has developed to the point that they are more liquid than many of the underlying bonds. Moreover, in contrast to the corporate CDS market, where trading has been concentrated largely in the 5-year maturity contract, CDS contracts at several maturity points between 1 and 10 years have been actively traded for several years. As such, a full term structure of CDS spreads is available for inferring default and recovery information from market data. This paper explores in depth the time-series properties of the risk-neutral mean arrival rates of credit events (λ Q ) implicit in the term structure of sovereign CDS spreads. Applying our framework to Mexico, Turkey, and Korea, three countries with different geopolitical characteristics and credit ratings, we ∗ Pan is with the MIT Sloan School of Management and NBER. Singleton is with the Graduate
903 citations
TL;DR: This article developed a small open economy model to study default risk and its interaction with output, consumption, and foreign debt, which predicts that default incentives and interest rates are higher in recessions, as observed in the data.
Abstract: Recent sovereign defaults in emerging countries are accompanied by interest rate spikes and deep recessions. This paper develops a small open economy model to study default risk and its interaction with output, consumption, and foreign debt. Default probabilities and interest rates depend on incentives for repayment. Default occurs in equilibrium because asset markets are incomplete. The model predicts that default incentives and interest rates are
higher in recessions, as observed in the data. The reason is that in a recession, a risk averse borrower finds it more costly to repay non-contingent debt and is more likely to default. In a quantitative exercise the model matches various features of the business cycle in Argentina
such as: high volatility of interest rates, higher volatility of consumption relative to output, a negative correlation of interest rates and output and a negative correlation of the trade balance and output. The model can also predict the recent default episode in Argentina.
783 citations
Posted Content•
TL;DR: In this paper, the relative financial strength of Islamic banks is assessed empirically based on evidence covering individual Islamic and commercial banks in 18 banking systems with a substantial presence of Islamic banking.
Abstract: The relative financial strength of Islamic banks is assessed empirically based on evidence covering individual Islamic and commercial banks in 18 banking systems with a substantial presence of Islamic banking. We find that (i) small Islamic banks tend to be financially stronger than small commercial banks; (ii) large commercial banks tend to be financially stronger than large Islamic banks; and (iii) small Islamic banks tend to be financially stronger than large Islamic banks, which may reflect challenges of credit risk management in large Islamic banks. We also find that the market share of Islamic banks does not have a significant impact on the financial strength of other banks.
665 citations
Posted Content•
TL;DR: This article showed that increased counterparty risk between banks contributed to the rise in spreads and found no empirical evidence that the TAF has reduced the widening spreads. But they did not consider the effect of the TFA on the spread of the OIBR.
Abstract: At the center of the financial market crisis of 2007-2008 was a highly unusual jump in spreads between the overnight inter-bank lending rate and term London inter-bank offer rates (Libor). Because many private loans are linked to Libor rates, the sharp increase in these spreads raised the cost of borrowing and interfered with monetary policy. The widening spreads became a major focus of the Federal Reserve, which took several actions -- including the introduction of a new term auction facility (TAF) --- to reduce them. This paper documents these developments and, using a no-arbitrage model of the term structure, tests various explanations, including increased risk and greater liquidity demands, while controlling for expectations of future interest rates. We show that increased counterparty risk between banks contributed to the rise in spreads and find no empirical evidence that the TAF has reduced spreads. The results have implications for monetary policy and financial economics.
630 citations
TL;DR: This paper found no evidence that increased counterparty risk contributed to the rise in interest rate spreads but do not find robust evidence that the TAF had a signifi cant effect on spreads.
Abstract: The recent fi nancial crisis saw a dramatic and persistent jump in interest rate spreads between overnight federal funds and longer term interbank loans. The Fed took several actions to reduce these spreads including the creation of the Term Auction Facility (TAF). The effectiveness of these policies depends on the cause of the increased spreads such as counterparty risk, liquidity, or other factors. Using a no-arbitrage pricing framework and various measures of risk, we firobust evidence that increased counterparty risk contributed to the rise in spreads but do not fi nd robust evidence that the TAF had a signifi cant effect on spreads. (JEL E43, E44, E52, G21)
456 citations
Posted Content•
TL;DR: In this paper, the authors investigated the relationship between regulations, competition, and risk-taking in the Central and Eastern European banking sectors between 1994 and 2005 and found no clear-cut positive relationship between conventional measures of banking sector regulatory reform and competition.
Abstract: This study investigates the relationship between regulations, competition, and risk-taking in the Central and Eastern European banking sectors between 1994 and 2005. We build an empirical model that employs a non-structural measure of competition, various proxies for regulations and both static and dynamic empirical frameworks. We find no clear-cut positive relationship between conventional measures of banking sector regulatory reform and competition. In contrast, the more specific regulatory features that relate to restrictions on bank activities, capital requirements and official supervisory power play an important role in shaping competition. We also find that market power is negatively associated with the risk-taking behaviour of banks, while capital requirements and supervisory power seem to be effective devices in monitoring risk-taking as they increase equity to capital ratios and decrease credit risk. Finally, incentives and tools that enhance market self-monitoring also promote credit-risk reduction.
401 citations
TL;DR: This paper provided the first empirical analysis of credit contagion via direct counterparty effects, finding that bankruptcy announcements cause negative abnormal equity returns and increases in CDS spreads for creditors, and that creditors with large exposures are more likely to suffer from financial distress later.
Abstract: Standard credit risk models cannot explain the observed clustering of default, sometimes described as "credit contagion." This paper provides the first empirical analysis of credit contagion via direct counterparty effects. We find that bankruptcy announcements cause negative abnormal equity returns and increases in CDS spreads for creditors. In addition, creditors with large exposures are more likely to suffer from financial distress later. This suggests that counterparty risk is a potential additional channel of credit contagion. Indeed, the fear of counterparty defaults among financial institutions explains the sudden worsening of the credit crisis after the Lehman bankruptcy in September 2008.
361 citations
TL;DR: This paper examined the relationship between banking sector reform and bank performance, measured in terms of efficiency, total factor productivity growth and net interest margin, accounting for the effects through competition and bank risk-taking.
Abstract: The aim of this study is to examine the relationship between banking sector reform and bank performance - measured in terms of efficiency, total factor productivity growth and net interest margin - accounting for the effects through competition and bank risk-taking. To this end, we develop an empirical model of bank performance, which is consistently estimated using recent econometric techniques. The model is applied to bank panel data from ten newly acceded EU countries. The results indicate that both banking sector reform and competition exert a positive impact on bank efficiency, while the effect of reform on total factor productivity growth is significant only toward the end of the reform process. Finally, the effect of capital and credit risk on bank performance is in most cases negative, while it seems that higher liquid assets reduce the efficiency and productivity of banks. © 2008 Elsevier B.V. All rights reserved.
342 citations
TL;DR: It is shown that neural networks can be very successful in learning and estimating the in bonis/default tendency of a borrower, provided that careful data analysis, data pre-processing and training are performed.
306 citations
TL;DR: In this paper, the authors explore the design, prevalence, and effectiveness of credit risk transfer and explore the costs and benefits of risk transfer in the context of credit derivatives and other financial innovations.
Abstract: Banks and other lenders often transfer credit risk in order to liberate capital for further loan intermediation. Beyond selling loans outright, lenders are increasingly active in the markets for syndicated loans, collateralized loan obligations (CLOs), credit default swaps, credit derivative product companies, “specialty finance companies,” and other financial innovations designed for credit risk transfer. My purpose here is to explore the design, prevalence, and effectiveness of credit risk transfer. My focus will be the costs and benefits for the
TL;DR: In this paper, the authors present an empirical study of the pricing effect of liquidity in the credit default swaps (CDS) market and construct liquidity proxies to capture various facets of CDS liquidity including adverse selection, search frictions, and inventory costs.
Abstract: We present an empirical study of the pricing effect of liquidity in the credit default swaps (CDS) market. We construct liquidity proxies to capture various facets of CDS liquidity including adverse selection, search frictions, and inventory costs. We show that the liquidity effect on CDS spreads is significant with an estimated liquidity premium on par with those of Treasury bonds and corporate bonds. Our finding of cross-sectional variations in the liquidity effect highlights the structure of the search-based over-the-counter market and the interplay between search friction and adverse selection in CDS trading. Using liquidity betas and volume respectively to measure liquidity risk, we find supporting evidence for liquidity risk being priced beyond liquidity level in the CDS market.
TL;DR: This article showed that the Merton model does not capture the interest rate sensitivity of corporate debt, which is substantially lower than would be expected from conventional duration measures, and that corporate bond prices are related to a number of marketwide factors such as the Fama-French SMB (small minus big) factor in a way that is not predicted by structural models.
TL;DR: In this paper, the authors employed cash flow and accounting based measures to examine performance differences between privately-owned and state-owned banks in sixteen Far East countries from 1989 through 2004, a period including the 1997 Asian financial crisis.
Abstract: This paper employs cash flow and accounting based measures to examine performance differences between privately-owned and state-owned banks in sixteen Far East countries from 1989 through 2004, a period including the 1997 Asian financial crisis. We find that state-owned banks operated less profitably, held less core capital, and had greater credit risk than privately-owned banks prior to 2001, and the performance differences are more significant in those countries with greater government involvement and political corruption in the banking system. In addition, from 1997 to 2000, the 4-year period after the beginning of the Asian financial crisis, the deterioration in the cash flow returns, core capital and credit quality of state-owned banks was significantly greater than that of privately-owned banks, and the contrast between the two types of banks during this period is especially sharp for the countries that were hardest hit by the Asian crisis. We also find that state-owned banks finance the government to a greater degree than do privately-owned banks in countries where the government is involved heavily in the banking system. However, state-owned banks closed the gap with privately-owned banks on cash flow returns, core capital, and nonperforming loans in the post-crisis period of 2001-2004. Taken together, our findings can best be explained by Shleifer and Vishny's (1997) corporate governance theory on government ownership of banks and Kane's (2000) life-cycle model of a regulation-induced banking crisis.
TL;DR: In this article, a panel of 186 European banks is used for the period 1992-2004 to determine if banking behaviors induced by the capital adequacy constraint and the provisioning system, amplify credit fluctuations.
TL;DR: In this article, the authors used data envelopment analysis (DEA) to investigate the efficiency of the Greek commercial banking industry over the period 2000-2004, and found that the inclusion of loan loss provisions as an input increases the efficiency scores, but off-balance sheet items do not have a significant impact.
TL;DR: In this paper, the role of sustainability and environmental orientation in the commercial credit risk management process is analyzed. And the authors show that sustainability criteria can be used to predict the financial performance of a debtor and improve the predictive validity of the credit rating process.
Abstract: Does a commercial debtor's economic, environmental and social performance in terms of sustainability affect its credit risk rating? Does adding criteria aimed at assessing a lender's environmental, social or sustainability practices provide added value to traditional financial rating criteria? Many analyses have reported that a correlation exists between companies' environmental and their financial performance. We checked out the assertion that it ‘pays to be sustainable’ by analyzing the role that criteria pertaining to sustainability and environmental orientation play in the commercial credit risk management process. Our results show that sustainability criteria can be used to predict the financial performance of a debtor and improve the predictive validity of the credit rating process. We conclude that the sustainability a firm demonstrates influences its creditworthiness as part of its financial performance. Copyright © 2008 John Wiley & Sons, Ltd and ERP Environment.
TL;DR: In this article, the authors exploit unique features of the U.S. municipal bond underwriting market to assess how political integrity affects primary financial market outcomes and show that state corruption and political connections have strong effects on several aspects of municipal bond sales and underwriting.
Abstract: We exploit unique features of the U.S. municipal bond underwriting market to assess how political integrity affects primary financial market outcomes. We show that state corruption and political connections have strong effects on several aspects of municipal bond sales and underwriting. Specifically, we find that higher state corruption is associated with greater credit risk, higher bond yields, greater use of external credit enhancement, and use of lower quality underwriters. States that are more corrupt can eliminate the corruption yield penalty by purchasing credit enhancements, effectively selling integrity-related default risk to an independent financial intermediary. Underwriting fees do not vary with cross-state corruption, but were significantly higher during an era when under writers routinely made political campaign contributions to win underwriting business. Furthermore, this pay-to-play underwriting fee premium exists only for negotiated bid bonds where underwriting business can be allocated on the basis of political favoritism. Overall, our results show a strong impact of state corruption and political connections on economic and financial outcomes.
TL;DR: In this paper, the authors investigate the effects of official fiscal data and creative accounting signals on interest rate spreads between bond yields in the European Union and find that two different measures of creative accounting indeed both increase the spread.
Abstract: We investigate the effects of official fiscal data and creative accounting signals on interest rate spreads between bond yields in the European Union. We find that two different measures of creative accounting indeed both increase the spread. The increase of the risk premium is stronger, if financial markets are unsure about the true extent of creative accounting. Moreover, fiscal transparency reduces risk premia. Instrumental variable regressions confirm these results by addressing potential reverse causality problems and measurement bias.
TL;DR: The authors decompose swap spreads into three components: a convenience yield from holding Treasuries, a credit risk element from the underlying LIBOR rate, and a factor specific to the swap market.
TL;DR: Investigation of the ability of neural nets, such as probabilistic neural nets and multi-layer feed-forward nets, and conventional techniques, in evaluating credit risk in Egyptian banks applying credit scoring models revealed that the neural nets-models gave a better average correct classification rate than the other techniques.
Abstract: Neural nets have become one of the most important tools using in credit scoring. Credit scoring is regarded as a core appraised tool of commercial banks during the last few decades. The purpose of this paper is to investigate the ability of neural nets, such as probabilistic neural nets and multi-layer feed-forward nets, and conventional techniques such as, discriminant analysis, probit analysis and logistic regression, in evaluating credit risk in Egyptian banks applying credit scoring models. The credit scoring task is performed on one bank's personal loans' data-set. The results so far revealed that the neural nets-models gave a better average correct classification rate than the other techniques. A one-way analysis of variance and other tests have been applied, demonstrating that there are some significant differences amongst the means of the correct classification rates, pertaining to different techniques.
Posted Content•
TL;DR: In this paper, the authors identify the drivers of the increase in risk premium contained in the interest rates on three-month interbank deposits at large, internationally active banks and identify the role of credit and liquidity factors.
Abstract: The risk premium contained in the interest rates on three-month interbank deposits at large, internationally active banks increased sharply in August 2007 and risk premiahave remained at an elevated level since. This feature aims to identify the drivers of this increase, in particular the role of credit and liquidity factors. While there is evidence of a role played by credit risk, at least at lower frequencies, the absence of a close relationship between the risk of default and risk premia in the money market, as well as the reaction of the interbank markets to central bank liquidity provisions, point to the importance of liquidity factors for banks’ day-to-day quoting behaviour.
TL;DR: In this article, the authors present fresh findings about key determinants of credit risk of commercial banks in emerging economy banking systems compared with developed economies, and find that anywhere from two to four factors are alone significantly correlated with credit risk.
Abstract: This paper presents fresh findings about key determinants of credit risk of commercial banks in emerging economy banking systems compared with developed economies.Australia, France, Japan and the US represent developed
economies; emerging economies are India, Korea, Malaysia, Mexico and Thailand.Credit risk theories and empirical literature suggest eight credit risk determinants.
We find anywhere from two to four factors are alone significantly correlated with credit risk of any one banking system.Regulatory capital is significant for banking systems that offer multi products; management quality is critical in the cases of loan-dominant banks in emerging economies.Contrary to theory or studies, we find leverage is not correlated with credit risk in our test period.Data transformations and statistical corrections ensured these results are reliable: Model robustness was tested using AIC.The model developed here could be applied to test more emerging economy banking systems to generalize our findings to other economies.
TL;DR: In this article, it was shown that neither sanctions nor reputation considerations are necessary to enforce repayment, and that positive borrowing can be sustained both in pooling and separating equilibria.
TL;DR: This paper investigated the effect of fiscal institutions such as the strength of the finance minister in the budget process and deficits on interest rate spreads of Eurozone countries and found that deficits significantly increase risk premia measured by relative swap spreads.
Abstract: We investigate the effect of fiscal institutions such as the strength of the finance minister in the budget process and deficits on interest rate spreads of Eurozone countries. Deficits significantly increase risk premia measured by relative swap spreads. The effect of deficits is significantly lower under EMU. This effect partly results from neglecting the role of fiscal institutions. After controlling for institutional changes, fiscal policy remains a significant determinant of risk premia in EMU. Better institutions are connected with lower risk premia. Furthermore deficits matter less for risk premia in countries with better institutions. Markets acknowledge that better institutions reduce fiscal difficulties rendering the monitoring of annual developments less important.
TL;DR: In this article, the authors developed a comprehensive new framework to measure and analyze sovereign risk, which is used to construct a marked-to-market balance sheet for the sovereign and derive a set of forwardlooking credit risk indicators that serve as a barometer of sovereign risk.
Abstract: This paper develops a comprehensive new framework to measure and analyze sovereign risk. Contingent claims analysis is used to construct a marked-to-market balance sheet for the sovereign and derive a set of forward-looking credit risk indicators that serve as a barometer of sovereign risk. Applications to 12 emerging market economies show the approach to be robust, and the risk indicators are a significant improvement over traditional macroeconomic vulnerability indicators and accounting-based measures. The framework can help policymakers design risk mitigation strategies and rank policy options using a calibrated structural model unique to each economy.
TL;DR: In this paper, the authors investigate the impact of volatility demand on option prices and find that the impact is positive and that the price impact increases by 40% as informational asymmetry about stock volatility intensifies in the days leading up to earnings announcements and diminishes to its normal level soon after the volatility uncertainty is resolved.
Abstract: This paper investigates informed trading on stock volatility in the option market. We construct non-market maker net demand for volatility from the trading volume of individual equity options and find that this demand is informative about the future realized volatility of underlying stocks. We also find that the impact of volatility demand on option prices is positive. More importantly, the price impact increases by 40% as informational asymmetry about stock volatility intensifies in the days leading up to earnings announcements and diminishes to its normal level soon after the volatility uncertainty is resolved. THE LAST SEVERAL DECADES have witnessed astonishing growth in the market for derivatives. The market’s current size of $200 trillion is more than 100 times greater than 30 years ago (Stulz (2004)). Accompanying this impressive growth in size has been an equally impressive growth in variety: The derivatives market now covers a broad spectrum of risk, including equity risk, interest rate risk, weather risk, and, most recently, credit risk and inflation risk. This phenomenal growth in size and breadth underscores the role of derivatives in financial markets and their economic value. While financial theory has traditionally emphasized the spanning properties of derivatives and their consequent ability to improve risk-sharing (Arrow (1964) and Ross (1976)), the role of derivatives as a vehicle for the trading of informed investors has emerged as another important economic function of these securities (Black (1975) and Grossman (1977)). We contribute to the body of knowledge on the economic value of derivatives by investigating the role of options as a mechanism for trading on information about future equity volatility. Our focus on informed volatility trading is motivated to a large extent by the fact that equity options are uniquely suited to investors with information about future volatility. Unlike traders with
TL;DR: In this paper, the authors used variation in access to a targeted lending program to estimate whether firms are credit constrained, and found that many of the firms must have been severely credit constrained and that the marginal rate of return to capital was very high for these firms.
Abstract: This paper uses variation in access to a targeted lending program to estimate whether firms are credit constrained. The basic idea is that while both constrained and unconstrained firms may be willing to absorb all the directed credit that they can get (because it may be cheaper than other sources of credit), constrained firms will use it to expand production, while unconstrained firms will primarily use it as a substitute for other borrowing. We apply these observations to firms in India that became eligible for directed credit as a result of a policy change in 1998, and lost eligibility as a result of the reversal of this reform in 2000. Using firms that were already getting this kind of credit before 1998, and retained eligibility in 2000 to control for time trends, we show that there is no evidence that directed credit is being used as a substitute for other forms of credit. Instead the credit was used to finance more production-there was a large acceleration in the rate of growth of sales and profits for these firms. We conclude that many of the firms must have been severely credit constrained, and that the marginal rate of return to capital was very high for these firms.
Book•
25 Aug 2008
TL;DR: In this article, a semi-Markov extension of the Black-Scholes model is proposed for finance and insurance risk models, as well as generalized non-homogeneous models for Pension Funds and Manpower Management.
Abstract: Probability Tools For Stochastic Modelling.- Renewal Theory and Markov Chains.- Markov Renewal Processes, Semi-Markov Processes and Markov Random Walks.- Discrete Time and Reward Smp and their Numerical Treatment.- Semi-Markov Extensions of the Black-Scholes Model.- Other Semi-Markov Models in Finance and Insurance.- Insurance Risk Models.- Reliability and Credit Risk Models.- Generalised Non-Homogeneous Models for Pension Funds and Manpower Management.
TL;DR: In this article, the authors analyzed a sample of banks that traded Credit Default Swaps and issued Collateralized Loan Obligations (CLOs) between 1997 and 2006 and found that after their first usage of either risk transfer method, these banks experienced a large and significant permanent increase in their share price beta.
Abstract: A main cause of the ongoing financial crisis is the various ways through which banks have transferred credit risk in the financial system. In this paper we study the riskiness of banks that have used these methods, as perceived by the market. For this we analyze a sample of banks that trade Credit Default Swaps (CDS) and a sample of banks that issued Collateralized Loan Obligations (CLOs) between 1997 and 2006. We find that after their first usage of either risk transfer method, these banks experience a large and significant permanent increase in their share price beta. This suggests that the market was aware of the risks arising from these methods, long before the actual onset of the crisis. We also address the question of the source of the beta effect by separating it into a volatility and a market correlation component. Quite strikingly we find that the increase in the beta is solely due to an increase in banks' correlations. The volatility of these banks' returns actually declines. This suggests that banks undertaking credit risk transfer activities may appear individually less risky, while actually posing a greater risk for the financial system. We argue that this posits a challenge for financial regulation, which has typically focused on the level of the individual institution.