Showing papers on "Credit risk published in 2012"
TL;DR: The authors showed that credit risk accounts for only a small fraction of yield spreads for investment-grade bonds of all maturities, with the fraction lower for bonds of shorter maturity.
Abstract: We show that credit risk accounts for only a small fraction of yield spreads for investment-grade bonds of all maturities, with the fraction lower for bonds of shorter maturities, and that it accounts for a much higher fraction of yield spreads for high-yield bonds This conclusion is shown to be robust across a wide class of structural models We obtain such results by calibrating each of the models to be consistent with data on the historical default loss experience and equity risk premia, and demonstrating that different models predict similar credit risk premia under empirically reasonable parameter choices
783 citations
TL;DR: In this article, the authors model both the CRA con-tiction of understating credit risk to attract more business, and the issuer con-fection of purchasing only the most favorable ratings (issuer shopping), and examine the eectiveness of a number of proposed regulatory solutions of CRAs.
Abstract: The spectacular failure of top-rated structured …nance products has brought renewed attention to the con‡icts of interest of Credit Rating Agencies (CRAs). We model both the CRA con‡ict of understating credit risk to attract more business, and the issuer con‡ict of purchasing only the most favorable ratings (issuer shopping), and examine the eectiveness of a number of proposed regulatory solutions of CRAs. We …nd that CRAs are more prone to in‡ate ratings when there is a larger fraction of naive investors in the market who take ratings at face value, or when CRA expected reputation costs are lower. To the extent that in booms the fraction of naive investors is higher, and the reputation risk for CRAs of getting caught understating credit risk is lower, our model predicts that CRAs are more likely to understate credit risk in booms than in recessions. We also show that, due to issuer shopping, competition among CRAs in a duopoly is less e¢ cient (conditional on the same equilibrium CRA rating policy) than having a monopoly CRA, in terms of both total ex-ante surplus and investor surplus. Allowing tranching decreases total surplus further. We argue that regulatory intervention requiring upfront payments for rating services (before CRAs propose a rating to the issuer) combined with mandatory disclosure of any rating produced by CRAs can substantially mitigate the con‡icts of interest of both CRAs and issuers.
577 citations
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TL;DR: The authors analyzed the drivers of sovereign risk for 31 advanced and emerging economies during the European sovereign debt crisis and found that a deterioration in countries' fundamentals and fundamentals contagion were the main explanations for the rise in sovereign yield spreads and CDS spreads during the crisis, not only for euro area countries but globally.
Abstract: The paper analyses the drivers of sovereign risk for 31 advanced and emerging economies during the European sovereign debt crisis. It shows that a deterioration in countries’ fundamentals and fundamentals contagion – a sharp rise in the sensitivity of financial markets to fundamentals – are the main explanations for the rise in sovereign yield spreads and CDS spreads during the crisis, not only for euro area countries but globally. By contrast, regional spill overs and contagion have been less important, including for euro area countries. The paper also finds evidence for herding contagion – sharp, simultaneous increases in sovereign yields across countries – but this contagion has been concentrated in time and among a few markets. Finally, empirical models with economic fundamentals generally do a poor job in explaining sovereign risk in the pre-crisis period for European economies, suggesting that the market pricing of sovereign risk may not have been fully reflecting fundamentals prior to the crisis.
426 citations
TL;DR: In this paper, the authors focus on manufacturing firms' innovative performance, measured by patent-based metrics, and employ exogenous variations in banking development arising from the staggered deregulation of banking activities across US states during the 1980s and 1990s.
Abstract: We present evidence that banking development plays a key role in technological progress. We focus on manufacturing firms’ innovative performance, measured by patent-based metrics, and employ exogenous variations in banking development arising from the staggered deregulation of banking activities across US states during the 1980s and 1990s. We find that interstate banking deregulation had significant beneficial effects on the quantity and quality of innovation activities, especially for firms highly dependent on external capital and located closer to entering banks. Furthermore, we find that these results are strongly driven by a greater ability of deregulated banks to geographically diversify credit risk.
425 citations
TL;DR: In this article, Chen et al. developed a theoretical model to analyze the interaction between debt market liquidity and credit risk through so-called rollover risk, which shows the role of short-term debt in exacerbating roll-over risk.
Abstract: Our model shows that deterioration in debt market liquidity leads to an increase in not only the liquidity premium of corporate bonds but also credit risk. The latter effect originates from firms’ debt rollover. When liquidity deterioration causes a firm to suffer losses in rolling over its maturing debt, equity holders bear the losses while maturing debtholdersare paidinfull.Thisconflictleadsthefirmto defaultatahigher fundamental threshold. Our model demonstrates an intricate interaction between the liquidity premium and default premium and highlights the role of short-term debt in exacerbating rollover risk. THE YIELD SPREAD OF a firm’s bond relative to the risk-free interest rate directly determines the firm’s debt financing cost, and is often referred to as its credit spread. It is widely recognized that the credit spread reflects not only a default premium determined by the firm’s credit risk but also a liquidity premium due to illiquidity of the secondary debt market (e.g., Longstaff, Mithal, and Neis (2005) and Chen, Lesmond, and Wei (2007)). However, academics and policy makers tend to treat both the default premium and the liquidity premium as independent, and thus ignore interactions between them. The financial crisis of 2007 to 2008 demonstrates the importance of such an interaction— deterioration in debt market liquidity caused severe financing difficulties for many financial firms, which in turn exacerbated their credit risk. In this paper, we develop a theoretical model to analyze the interaction between debt market liquidity and credit risk through so-called rollover risk: when debt market liquidity deteriorates, firms face rollover losses from issuing new bonds to replace maturing bonds. To avoid default, equity holders need to bear the rollover losses, while maturing debt holders are paid in full. This
329 citations
TL;DR: In this paper, the authors provide an empirical reconstruction of the US CDS network based on the FDIC Call Reports for off-balance sheet bank data for the 4th quarter in 2007 and 2008.
Abstract: A small segment of credit default swaps (CDS) on residential mortgage backed securities (RMBS) stand implicated in the 2007 financial crisis. The dominance of a few big players in the chains of insurance and reinsurance for CDS credit risk mitigation for banks’ assets has led to the idea of too interconnected to fail (TITF) resulting, as in the case of AIG, of a tax payer bailout. We provide an empirical reconstruction of the US CDS network based on the FDIC Call Reports for off balance sheet bank data for the 4th quarter in 2007 and 2008. The propagation of financial contagion in networks with dense clustering which reflects high concentration or localization of exposures between few participants will be identified as one that is TITF. Those that dominate in terms of network centrality and connectivity are called ‘super-spreaders’. Management of systemic risk from bank failure in uncorrelated random networks is different to those with clustering. As systemic risk of highly connected financial firms in the CDS (or any other) financial markets is not priced into their holding of capital and collateral, we design a super-spreader tax based on eigenvector centrality of the banks which can mitigate potential socialized losses.
289 citations
TL;DR: In this paper, the authors find that three factors can explain the recorded developments in sovereign spreads: an aggregate regional risk factor, the country-specific credit risk and the spillover effect from Greece.
Abstract: Since the intensification of the crisis in September 2008, all euro area long-term government bond yields relative to the German Bund have been characterized by highly persistent processes with upward trends for countries with weaker fiscal fundamentals. Looking at the daily period 1 September 2008 - 4 August 2011, we find that three factors can explain the recorded developments in sovereign spreads: an aggregate regional risk factor, the country-specific credit risk and the spillover effect from Greece. Specifically, higher risk aversion has increased the demand for the Bund and this is behind the pricing of all euro area spreads, including those for Austria, Finland and the Netherlands. Country-specific credit ratings have played a key role in the developments of the spreads for Greece, Ireland, Portugal and Spain. Finally, the rating downgrade in Greece has contributed to developments in spreads of countries with weaker fiscal fundamentals: Ireland, Portugal, Italy, Spain, Belgium and France.
286 citations
TL;DR: In this article, the authors explore the dynamics of default cascades in a network of credit interlink-ages in which each agent is at the same time a borrower and a lender.
283 citations
TL;DR: This article found that firms with higher cash holdings should be'safer' and have lower credit spreads, which can be explained by the precautionary motive for saving cash, which in their model causes riskier firms to accumulate higher cash reserves.
Abstract: Intuition suggests that firms with higher cash holdings should be 'safer' and have lower credit spreads. Yet empirically, the correlation between cash and spreads is robustly positive. This puzzling finding can be explained by the precautionary motive for saving cash, which in our model causes riskier firms to accumulate higher cash reserves. In contrast, spreads are negatively related to the part of cash holdings that is not determined by credit risk factors. Similarly, although firms with higher cash reserves are less likely to default in the short term, endogenously determined liquidity may be related positively to the longer-term probability of default. Our empirical analysis confirms these predictions, suggesting that precautionary savings are central to understanding the effects of cash on credit risk.
269 citations
TL;DR: In this paper, the authors provide a study of bond yield differentials among EU government bonds issued between 1993 and 2005 on the basis of a unique dataset of issue spreads in the US and DM (Euro) bond market Interest differentials between bonds issued by EU countries and Germany or the USA contain risk premiums which increase with fiscal imbalance and depend negatively on the issuer's relative bond market size.
268 citations
TL;DR: In this paper, the authors investigate whether liquidity is an important price factor in the US corporate bond market, and find that liquidity effects account for approximately 14% of the explained market-wide corporate yield spread changes.
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TL;DR: In this paper, the authors investigate whether liquidity is an important price factor in the US corporate bond market and find that liquidity factors account for approximately 14% of the explained market-wide corporate yield spread changes.
Abstract: We investigate whether liquidity is an important price factor in the US corporate bond market. In particular, we focus on whether liquidity eects are more pronounced in periods of nancial crises, especially for bonds with high credit risk, using a unique data set covering more than 20,000 bonds, between October 2004 and December 2008. We employ a wide range of liquidity measures and nd that liquidity eects account for approximately 14% of the explained market-wide corporate yield spread changes. We conclude that the economic impact of the liquidity measures is signicantly larger in periods of crisis, and for speculative grade bonds.
TL;DR: The authors showed that credit risk accounts for only a small fraction of yield spreads for investment-grade bonds of all maturities, with the fraction lower for bonds of shorter maturity, and that it accounts for a much higher fraction of yields for high yield bonds.
Abstract: We show that credit risk accounts for only a small fraction of yield spreads for investment-grade bonds of all maturities, with the fraction lower for bonds of shorter maturities, and that it accounts for a much higher fraction of yield spreads for high yield bonds. This conclusion is shown to be robust across a wide class of structural models. We obtain such results by calibrating each of the models to be consistent with data on the historical default loss experience and equity risk premia, and demonstrating that different models predict similar credit risk premia under empirically reasonable parameter choices.
TL;DR: In this paper, the authors study the exposure of the U.S. corporate bond returns to liquidity shocks of stocks and treasury bonds over the period 1973-2007 in a regime switching model.
Abstract: We study the exposure of the U.S. corporate bond returns to liquidity shocks of stocks and treasury bonds over the period 1973-2007 in a regime switching model. In one regime, liquidity shocks have mostly insignificant effect on bond prices, whereas in another regime, a rise in illiquidity produces significant but conflicting effects: Prices of investment-grade bonds rise while prices of speculative grade (junk) bonds fall substantially (relative to the market). Relating the probability of these regimes to macroeconomic conditions we find that the second regime can be predicted by economic conditions that are characterized as “stress.” These effects, which are robust to controlling for other systematic risks (term and default), suggest the existence of time-varying liquidity risk of corporate bond returns conditional on episodes of flight to liquidity. Our model can predict the out-of-sample bond returns for the stress years 2008-2009. We find a similar pattern for stocks classified by high or low book-to-market ratio, where again liquidity shocks play a special role in periods characterized by adverse economic conditions.
TL;DR: In this paper, the authors carried out an empirical investigation into the quantitative effect of credit risk on the performance of commercial banks in Nigeria over the period of 11 years (2000-2010).
Abstract: The study carried out an empirical investigation into the quantitative effect of credit risk on the performance of commercial banks in Nigeria over the period of 11 years (2000-2010). Five commercial banking firms were selected on a cross sectional basis for eleven years. The traditional profit theory was employed to formulate profit, measured by Return on Asset (ROA), as a function of the ratio of Non-performing loan to loan & Advances (NPL/LA), ratio of Total loan & Advances to Total deposit (LA/TD) and the ratio of loan loss provision to classified loans (LLP/CL) as measures of credit risk. Panel model analysis was used to estimate the determinants of the profit function. The results showed that the effect of credit risk on bank performance measured by the Return on Assets of banks is cross-sectional invariant. That is the effect is similar across banks in Nigeria, though the degree to which individual banks are affected is not captured by the method of analysis employed in the study. A 100 percent increase in non-performing loan reduces profitability (ROA) by about 6.2 percent, a 100 percent increase in loan loss provision also reduces profitability by about 0.65percent while a 100 percent increase in total loan and advances increase profitability by about 9.6 percent. Based on our findings, it is recommended that banks in Nigeria should enhance their capacity in credit analysis and loan administration while the regulatory authority should pay more attention to banks’ compliance to relevant provisions of the Bank and other Financial Institutions Act (1999) and prudential guidelines.
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TL;DR: This paper studied the liquidity demand of large settlement (first-tier) banks in the UK and its effect on the Sterling money markets before and during the sub-prime crisis of 2007-08.
Abstract: We study the liquidity demand of large settlement (first-tier) banks in the UK and its effect on the Sterling Money Markets before and during the sub-prime crisis of 2007-08 Liquidity holdings of large settlement banks experienced on average a 30% increase in the period immediately following 9th August, 2007, the day when money markets froze, igniting the crisis In the UK, unlike in the US until October 2008, the remuneration of reserves accounts provides strong incentives for banks to park liquidity at the central bank rather than lend in the market We show that following this structural break, settlement bank liquidity had a precautionary nature in that it rose on calendar days with a large amount of payment activity and for banks with greater credit risk We establish that the liquidity demand by settlement banks caused overnight inter-bank rates to rise and volumes to decline, an effect virtually absent in the pre-crisis period This liquidity effect on inter-bank rates occurred in both unsecured borrowing as well as borrowing secured by UK government bonds Further, using bilateral data we show that the effect was more strongly linked to lender risk than to borrower risk
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TL;DR: In this paper, the authors develop a dynamic model of debt runs on a medium-sized bank, which invests in an illiquid asset by rolling over staggered short-term debt contracts.
Abstract: We develop a dynamic model of debt runs on a …rm, which invests in an illiquid asset by rolling over staggered short-term debt contracts (i.e., dierent contracts mature at dierent times.) We derive a unique threshold equilibrium, in which creditors coordinate their asynchronous rollover decisions based on the …rm's publicly observable and time-varying fundamental. The coordination problem ampli…es the creditors'concerns about the …rm's future rollover risk created by its time-varying fundamental, and causes each maturing creditor to run ahead of others even when the current fundamental is substantially higher than its liability. Our model provides a set of implications on the roles played by volatility, illiquidity and debt maturity in driving debt runs, as well as on …rms'capital adequacy standards and credit risk.
TL;DR: This article found that firms with traded CDS contracts on their debt are able to maintain higher leverage ratios and longer debt maturities during periods in which credit constraints become binding, as would be expected if the ability to hedge helps alleviate frictions on the supply side of credit markets.
Abstract: Does the ability of suppliers of corporate debt capital to hedge risk through credit default swap (CDS) contracts impact firms' capital structures? We find that firms with traded CDS contracts on their debt are able to maintain higher leverage ratios and longer debt maturities. This is especially true during periods in which credit constraints become binding, as would be expected if the ability to hedge helps alleviate frictions on the supply side of credit markets.
TL;DR: This paper used principal components analysis to identify common factors in the movement of banks' credit default swap spreads and found that the importance of common factors rose steadily to exceptional levels from the outbreak of the Subprime crisis to past the rescue of Bear Stearns, reflecting a diffuse sense that funding and credit risk was increasing.
TL;DR: In this article, the authors examine the relation between deposit insurance and bank risk and systemic fragility in the years leading up to and during the recent financial crisis and find that generous financial safety nets increase bank risk, and that good bank supervision can alleviate the unintended consequences of deposit insurance on bank systemic risk during good times.
Abstract: Deposit insurance is widely offered in a number of countries as part of a financial system safety net to promote stability. An unintended consequence of deposit insurance is the reduction in the incentive of depositors to monitor banks which lead to excessive risk-taking. We examine the relation between deposit insurance and bank risk and systemic fragility in the years leading up to and during the recent financial crisis. We find that generous financial safety nets increase bank risk and systemic fragility in the years leading up to the global financial crisis. However, during the crisis, bank risk is lower and systemic stability is greater in countries with deposit insurance coverage. Our findings suggest that the “moral hazard effect” of deposit insurance dominates in good times while the “stabilization effect” of deposit insurance dominates in turbulent times. The overall effect of deposit insurance over the full sample we study remains negative since the destabilizing effect during normal times is greater in magnitude compared to the stabilizing effect during global turbulence. In addition, we find that good bank supervision can alleviate the unintended consequences of deposit insurance on bank systemic risk during good times, suggesting that fostering the appropriate incentive framework is very important for ensuring systemic stability.
TL;DR: In this article, the authors explore commonalities across asset-pricing anomalies and assess implications of financial distress for the profitability of anomaly-based trading strategies, including price momentum, earnings momentum, credit risk, dispersion, idiosyncratic volatility, and capital investments.
Abstract: This paper explores commonalities across asset-pricing anomalies. In particular, we assess implications of financial distress for the profitability of anomaly-based trading strategies. Strategies based on price momentum, earnings momentum, credit risk, dispersion, idiosyncratic volatility, and capital investments derive their profitability from taking short positions in high credit risk firms that experience deteriorating credit conditions. In contrast, the value-based strategy derives most of its profitability from taking long positions in high credit risk firms that survive financial distress and subsequently realize high returns. The accruals anomaly is an exception - it is robust among high and low credit risk firms in all credit conditions.
TL;DR: In this article, the authors review studies of the impact of credit constraints on the accumulation of human capital and highlight the importance of early childhood investments, as their response largely determines the impact on the overall lifetime acquisition of human resources.
Abstract: We review studies of the impact of credit constraints on the accumulation of human capital. Evidence suggests that credit constraints have recently become important for schooling and other aspects of households' behavior. We highlight the importance of early childhood investments, as their response largely determines the impact of credit constraints on the overall lifetime acquisition of human capital. We also review the intergenerational literature and examine the macroeconomic impacts of credit constraints on social mobility and the income distribution. A common limitation across all areas of the human capital literature is the imposition of ad hoc constraints on credit. We propose a more careful treatment of the structure of government student loan programs and the incentive problems underlying private credit. We show that endogenizing constraints on credit for human capital helps explain observed borrowing, schooling, and default patterns and offers new insights about the design of government policy.
TL;DR: In this paper, the authors show that the correlation between cash and spreads is robustly positive and higher for lower credit ratings, which can be explained by the precautionary motive for saving cash.
Abstract: Intuition suggests that rms with higher cash holdings are safer and should have lower credit spreads. Yet empirically the correlation between cash and spreads is robustly positive, and higher for lower credit ratings. This puzzling nding can be explained by the precautionary motive for saving cash. In our model endogenously determined optimal cash reserves are positively related to credit risk, resulting in a spurious positive correlation between cash and spreads. By contrast, spreads are negatively related to the \exogenous" component of cash holdings independent of credit risk factors. Similarly, although rms with higher cash reserves are less likely to default over short horizons, longer term endogenously determined liquidity may be positively related to the probability of default. Our empirical analysis conrms these predictions, suggesting that endogenous precautionary savings are central to understanding the eects of cash on credit risk.
TL;DR: In this article, the authors examined how counterparty credit risk is actually priced in the CDS market and found that the effect of counterparty risk is vanishingly small and consistent with a market structure in which participants require collateralization of swap liabilities by counterparties.
TL;DR: This article explored how general economic conditions impact defaults and major credit rating changes by fitting reduced-form Cox intensity models with a broad range of macroeconomic and firm-specific ratings-related variables.
TL;DR: In this article, the authors argue that a significant part of the surge in the spreads of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) countries in the eurozone during 2010-11 was disconnected from underlying increases in the debt-to-GDP (gross domestic product) ratios.
Abstract: This article presents evidence that a significant part of the surge in the spreads of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) countries in the eurozone during 2010-11 was disconnected from underlying increases in the debt-to-GDP (gross domestic product) ratios, and was the result of negative market sentiments that became very strong since the end of 2010. It is argued that the systematic mispricing of sovereign risk in the eurozone intensifies macroeconomic instability, leading to bubbles in good years and excessive austerity in bad years.
01 Jan 2012
TL;DR: In this paper, the impact of credit risk on the profitability of Nigerian banks was analyzed using Descriptive, Correlation and Regression techniques, which revealed that credit risk management has a significant impact on profitability of Nigeria banks, therefore, management need to be cautious in setting up a credit policy that might not negatively affect profitability.
Abstract: Recently banks witnessed rising non-performing credit portfolios and these significantly contributed to financial distress in the banking sector. Banks collect deposits and lends to customers but when customers fail to meet their obligations problems such as non-performing loans arise. This study evaluates the impact of credit risk on the profitability of Nigerian banks. Financial ratios as measures of bank performance and credit risk were the data collected from secondary sources mainly the annual reports and accounts of sampled banks from 2004 - 2008. Descriptive, correlation and regression techniques were used in the analysis. The findings revealed that credit risk management has a significant impact on the profitability of Nigeria banks. Therefore, management need to be cautious in setting up a credit policy that might not negatively affects profitability and also they need to know how credit policy affects the operation of their banks to ensure judicious utilization of deposits.
TL;DR: In this paper, the authors analyzed the dynamics of the credit default swap (CDS) market of PIIGS, France, Germany and the UK for the period of 2005-2010.
Abstract: This paper analyses the dynamics of the credit default swap (CDS) market of PIIGS, France, Germany and the UK for the period of 2005–2010. The study is performed on the basis of the Datastream and DTCC data on CDS spreads and the BIS data on cross-border exposures. The analysis of the data shows that sovereign risk mainly concentrates in the EU countries. The EWMA correlation analysis and the Granger-causality test demonstrate that there was contagion effect since correlations and cross-county interdependencies increased already after August 2007. Furthermore, the IRF analysis shows that among PIIGS the CDS markets of Spain and Ireland have the biggest impact on the European CDS market, whereas the CDS market of the UK does not cause a big distress in the Eurozone. The adjusted correlation analysis confirms that Greece and other PIIGS (even Spain and Italy) have lower capacity to trigger contagion than core EU countries. Besides, Portugal is the most vulnerable country in the sample, whereas the UK is the most immune to shocks.
TL;DR: In this first large-scale LGD benchmarking study, various regression techniques for modeling and predicting LGD are investigated and there is a clear trend that non-linear techniques, and in particular support vector machines and neural networks, perform significantly better than more traditional linear techniques.
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TL;DR: In this paper, the authors investigate bank capital, charter value, off-balance sheet activities, dividend payout ratio and size as determinants of bank equity risk (systematic risk, total risk, interest rate risk and idiosyncratic risk) and credit risk.
Abstract: We investigate bank capital, charter value, off-balance sheet activities, dividend payout ratio and size as determinants of bank equity risk (systematic risk, total risk, interest rate risk and idiosyncratic risk) and credit risk. Using information for 117 financial institutions across 15 European countries over the period 1996-2010, we find evidence of a convex (U-shaped) relation between bank capital and bank systematic risk and credit risk. We find mixed evidence on the relation between charter value and our measures of bank risk. The results also show a positive association between off-balance sheet activities and bank risk. It is also evident that dividend payout ratio is negatively related to all risk measures. We find large banks reflect higher total risk and lower credit risk. Following the creation of the Economic Monetary Union, we also observe an increase in bank risk sensitivity to both bank capital and off-balance sheet activities and a decrease in the sensitivity of bank risk to charter value. Finally, with regard to the impact of the recent global financial crisis, we find that the largest decline in the coefficient value is observed for bank capital relative to credit risk. These results are robust to various model specifications.