Credit risk

About: Credit risk is a research topic. Over the lifetime, 18595 publications have been published within this topic receiving 382866 citations.

Did Risk-Based Capital Allocate Bank Credit and Cause a `Credit Crunch' in the U.S.?

Abstract: This paper examines the reallocation of bank credit from loans to securities in the early 1990s using data on virtually all U.S. banks from 1979 to 1992. The spectacular increase in bank and thrift failures in the 1980s raised concerns about depository institution risk and spurred interest in public policy prescriptions to reduce this risk. One of these pre-scriptions was the Basle Accord on risk-based capital, which mandates that international banks operating in the major industrialized nations hold capital in proportion to their perceived credit risks. Because capital is more expensive to raise than insured deposits, risk-based capital (RBC) may be viewed as a regulatory tax that is higher on assets in categories that are assigned higher risk weights. Therefore, it would be expected that implementation of RBC would encourage substitution out of assets in the 100% risk category, such as commercial loans, and into assets in the 0% risk category, such as Treasury securities. Thus, the allocation of credit away from commercial loans may have caused a "credit crunch," which the authors define as a significant reduction in the supply of credit available to commercial borrowers. Consistent with these expectations, U.S. banks did reduce their commercial loans and increase their holdings of Treasuries in the early 1990s. A number of alternative explanations for this change in bank behavior have been offered. The authors suggest several other hypotheses including the leverage credit crunch hypothesis reflecting banks' interest in reducing their required leverage capital ratio; the loan examination credit crunch hypothesis reflecting the more rigorous examination process which encouraged substitution into safe assets; the voluntary risk retrenchment credit crunch hypothesis reflecting management's voluntary substitution of safer assets to lower the cost of funding and reduce the risk of bankruptcy; and the macro/regional demand-side hypo-thesis reflecting the reduction in overall loan demand because of the downturn in the economy and the steep slope of the term structure. An additional hypothesis is that the decline in commercial lending reflects continuation of longer term trends in the declining demand for bank intermediation services. Unfortunately, all of these hypotheses are roughly consistent with the aggregate data, leaving unknown whether risk-based capital played a major part in the reallocation of bank credit or whether a supply side "credit crunch" even existed. It is possible that all of the theories were correct simultaneously. The paper takes a close look at the data at the micro bank level to try to distinguish among the alternative hypotheses, with emphasis on RBC. The method used by the authors is to examine how bank portfolios changed in the early 1990s from the 1980s, and to see how these changes are related to the risk-based capital ratios and other key variables. The authors' tests relate the growth rates of bank asset categories to several measures of perceived bank risk, including the Tier 1 and Total RBC ratios. The findings suggest that the RBC credit crunch hypothesis fares the worst of all the alternative explanations of the bank credit reallocation of the 1990s. They find that the effects of the RBC ratios on lending did not get consistently stronger in the early 1990s, and that the Tier 1 and Total RBC ratios generally acted to counteract each other in their effect on credit allocation. The other credit crunch theories examined are somewhat more consistent with the data, given that the relations to the leverage ratio and the "problem" loan categories generally have the predicted signs. However, the quantitative effects are not substantial. The only other evidence that is roughly consistent with the credit crunch hypotheses is that large banks, banks with weaker capital ratios, and banks supervised by the OCC have much more substantial credit allocation effects and greater lending reactions to perceived risk than do other banks. While it is difficult to disentangle these groups, since large banks tend to have weaker capital ratios and national charters, in none of these groups are most of the decreases attributable to the credit crunch hypothesis directly. The authors note that the findings do not rule out non-risk related credit crunch expla-nations. The authors state that such theories cannot be easily identified econometrically because they are not associated with observ-able variables on which to base a test. They conclude that the demand-side effects on lending are relatively strong, but exact attribution to the different hypotheses cannot be determined from their model.

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. …

World Bank/GEF Solar Home Systems Projects : experiences and lessons learned 1993-2000

Abstract: Twelve projects provide energy services to off-grid rural households in developing countries by enhancing markets for solar home systems and by removing barriers to their dissemination. Project approaches are reviewed, along with early implementation experience and lessons suggested by experience. Most projects incorporate the following features: pilot private-sector and NGO delivery models; pilot consumer credit delivery mechanisms; pay first-cost subsidies and offer affordable system sizes; support policy development and capacity; develop codes and standards and establish certification, testing, and enforcement institutions; and conduct consumer awareness and marketing programs. Most projects are just beginning implementation; a few are almost completed. Lessons from early experience suggest that: solar home system delivery firms face a myriad of difficulties operating in rural areas; credit risk is a serious concern of both financiers and dealers and makes credit sales particularly challenging; technical performance of systems is becoming well-proven; customers desire a range of component options and service levels and can benefit from even small systems; projects must recognize the link between rural electric-grid extension and solar home system demand; and marketing campaigns can be extremely costly and time consuming in rural areas. Challenges are to demonstrate sustainable and replicable business models, develop regulatory models for energy-service concessions, and integrate rural electrification policy with solar home system delivery.

Credit-Market Sentiment and the Business Cycle

Abstract: Using U.S. data from 1929 to 2015, we show that elevated credit-market sentiment in year t-2 is associated with a decline in economic activity in years t and t+1. Underlying this result is the existence of predictable mean reversion in credit-market conditions. When credit risk is aggressively priced, spreads subsequently widen. The timing of this widening is, in turn, closely tied to the onset of a contraction in economic activity. Exploring the mechanism, we find that buoyant credit-market sentiment in year t-2 also forecasts a change in the composition of external finance: Net debt issuance falls in year t, while net equity issuance increases, consistent with the reversal in credit-market conditions leading to an inward shift in credit supply. Unlike much of the current literature on the role of financial frictions in macroeconomics, this paper suggests that investor sentiment in credit markets can be an important driver of economic fluctuations.