Showing papers on "Financial risk published in 2009"
TL;DR: In this paper, the authors conduct an empirical assessment of theories concerning risk taking by banks, their ownership structures, and national bank regulations, and show that bank risk taking varies positively with the comparative power of shareholders within the corporate governance structure of each bank.
1,965 citations
TL;DR: This paper explores and integrates the various advantages of online banking to form a positive factor named perceived benefit and draws from perceived risk theory to propose a theoretical model to explain customers' intention to use online banking.
1,596 citations
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TL;DR: The Kansas City Financial Stress Index (KCFSI) as discussed by the authors measures the degree of financial stress in the stock market, and it has been shown that high values of the KCFSI have tended to coincide with known periods of economic stress.
Abstract: (ProQuest: ... denotes formulae omitted.)The U.S. economy is currently experiencing a period of significant financial stress. This stress has contributed to the downturn in the economy by boosting the cost of credit and making businesses, households, and financial institutions highly cautious. To alleviate the financial stress and counteract its effects on the economy, the Federal Reserve has reduced the federal funds rate target substantially and undertaken unprecedented actions to support the functioning of financial markets. There will come a point, however, when the Federal Reserve needs to remove liquidity from the economy and unwind special lending programs to ensure a return to sustainable growth with low inflation.In past recoveries, the decision when to tighten policy was based mainly on the strength of business and consumer spending and the degree of upward pressure on prices and wages. An additional element in the current exit strategy will be determining if financial stress is no longer high enough to endanger economic recovery. As financial conditions begin to improve, the various measures of financial stress that the Federal Reserve monitors may give mixed signals. In this situation, policymakers would greatly benefit from having a single, comprehensive index of financial stress. Such an index could also prove valuable further down the road, when the Federal Reserve might again need to decide whether financial stress was serious enough to warrant special attention.This article presents a new index of financial stress - the Kansas City Financial Stress Index (KCFSI). The article explains how the components of the KCFSI capture key aspects of financial stress and shows that high values of the KCFSI have tended to coincide with known periods of financial stress. The article also shows that the KCFSI provides valuable information about future economic growth.The first section of the article discusses the key phenomena that economists generally associate with financial stress. The next section describes the set of financial variables selected to represent these features of financial stress and explains how the variables are combined in the KCFSI. The third section examines the behavior of the KCFSI during past episodes of financial stress and explains how the index can be used to determine the severity of financial stress. The fourth section examines the link between the KCFSI and economic activity, including the transmission of financial stress to economic activity through changes in bank lending standards.I. KEY FEATURES OF FINANCIAL STRESSIn most general terms, financial stress can be thought of as an interruption to the normal functioning of financial markets. Agreeing on a more specific definition is not easy, because no two episodes of financial stress are exactly the same. Still, economists tend to associate certain key phenomena with financial stress. The relative importance of these phenomena may differ from one episode of financial stress to another. However, every episode seems to involve at least one of the phenomena, and often all of them.Increased uncertainty about fundamental value of assets. One common sign of financial stress is increased uncertainty among lenders and investors about the fundamental values of financial assets. The fundamental value of an asset is the present discounted value of the future cash flows, such as dividends and interest payments. Increased uncertainty about these fundamental values typically translates into greater volatility in the market prices of the assets.In some cases, increased uncertainty about the fundamental values of assets reflects greater uncertainty about the outlook for rhe economy as a whole and for specific sectors. The prospective cash flows from stocks, bonds, and loans all depend on future economic conditions. As a result, heightened uncertainty about economic conditions can cause lenders and investors to become less sure of the present discounted values of these cash flows. …
467 citations
TL;DR: The authors empirically evaluates four types of costs that may result from an international sovereign default: reputational costs, international trade exclusion costs, costs to the domestic economy through the financial system, and political costs to authorities.
Abstract: This paper empirically evaluates four types of costs that may result from an international sovereign default: reputational costs, international trade exclusion costs, costs to the domestic economy through the financial system, and political costs to the authorities. It finds that the economic costs are generally significant but short-lived, and sometimes do not operate through conventional channels. The political consequences of a debt crisis, by contrast, seem to be particularly dire for incumbent governments and finance ministers, broadly in line with what happens in currency crises.
312 citations
TL;DR: The authors examined the effect of derivative use on firm risk and value using a large sample of non-financial firms from 47 countries and found strong evidence that the use of financial derivatives reduces both total risk and systematic risk.
Abstract: Using a large sample of non-financial firms from 47 countries, we examine the effect of derivative use on firm risk and value. We control for endogeneity by matching users and non-users on the basis of their propensity to hedge. We also use a new technique to estimate the effect of omitted variable bias on our inferences. We find strong evidence that the use of financial derivatives reduces both total risk and systematic risk. The effect of derivative use on firm value is positive but more sensitive to endogeneity and omitted variable concerns. However, hedging with derivatives is associated with significantly higher value, abnormal returns, and larger profits during the economic down-turn in 2001-2002, suggesting firms are hedging downside risk.
296 citations
31 May 2009
TL;DR: This work applies well-known regression techniques to a large corpus of freely available financial reports, constructing regression models of volatility for the period following a report, rivaling past volatility in predicting the target variable.
Abstract: We address a text regression problem: given a piece of text, predict a real-world continuous quantity associated with the text's meaning. In this work, the text is an SEC-mandated financial report published annually by a publicly-traded company, and the quantity to be predicted is volatility of stock returns, an empirical measure of financial risk. We apply well-known regression techniques to a large corpus of freely available financial reports, constructing regression models of volatility for the period following a report. Our models rival past volatility (a strong baseline) in predicting the target variable, and a single model that uses both can significantly outperform past volatility. Interestingly, our approach is more accurate for reports after the passage of the Sarbanes-Oxley Act of 2002, giving some evidence for the success of that legislation in making financial reports more informative.
286 citations
TL;DR: In this article, a new concept of Granger causality in risk is introduced and a class of kernel-based tests are proposed to detect extreme downside risk spillover between financial markets, where risk is measured by the left tail of the distribution or equivalently by the Value at Risk (VaR).
274 citations
TL;DR: In this paper, the authors provide an empirical evaluation of the patterns of risk sharing among different groups of countries and examine how international financial integration has affected the evolution of these patterns using a variety of empirical techniques, and conclude that there is at best a modest degree of international risk sharing, and certainly nowhere near the levels predicted by theory.
273 citations
TL;DR: In this article, a large sample of bank loans issued to U.S. firms between 1990 and 2004 was used to investigate the link between a firm's governance structure and its cost of capital, and they found that firms that rely too much on corporate control market as a governance device are punished by costlier bank loans.
Abstract: Using a large sample of bank loans issued to U.S. firms between 1990 and 2004, we find that lower takeover defenses (as proxied by the lower G-index of Gompers, Ishii, and Metrick 2003) significantly increase the cost of loans for a firm. Firms with lowest takeover defense (democracy) pay a 25% higher spread on their bank loans as compared with firms with the highest takeover defense (dictatorship), after controlling for various firm and loan characteristics. Further investigations indicate that banks charge a higher loan spread to firms with higher takeover vulnerability mainly because of their concern about a substantial increase in financial risk after the takeover. Our results have important implications for understanding the link between a firm's governance structure and its cost of capital. Our study suggests that firms that rely too much on corporate control market as a governance device are punished by costlier bank loans. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.
239 citations
TL;DR: In this article, the authors developed a general framework for supply contracts in which portfolios of contracts can be analyzed and optimized, focusing on a multi-period environment with convex contract, spot market, and inventory holding costs.
Abstract: The purpose of this paper is to develop a general framework for supply contracts in which portfolios of contracts can be analyzed and optimized. We focus on a multi-period environment with convex contract, spot market, and inventory holding costs. We specialize the model to the case of a portfolio consisting of option contracts. We characterize the optimal replenishment policy and show that it has a simple structure. Namely, the use of every different option contract and the spot market is dictated by a modified base-stock policy. In addition, we derive conditions to determine when an option is relatively attractive compared to other options or the spot market. Finally, we present our computational study, where we report the sensitivity of the results to the parameters of the model. Our experiments indicate that portfolio contracts not only increase the manufacturer's expected profit, but can also reduce its financial risk.
232 citations
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TL;DR: In this article, the authors examined the intertemporal relation between risk and expected stock returns and found a positive and significant relation between negative risk and portfolio returns on NYSE/AMEX/Nasdaq stocks.
Abstract: This paper examines the intertemporal relation between downside risk and expected stock returns. Value at risk (VaR), expected shortfall, and tail risk are used as measures of downside risk to determine the existence and significance of a risk-return tradeoff. We find a positive and significant relation between downside risk and the portfolio returns on NYSE/AMEX/Nasdaq stocks. VaR remains a superior measure of risk when compared to the traditional risk measures. These results are robust across different stock market indices, different measures of downside risk, loss probability levels, and after controlling for macroeconomic variables and volatility over different holding periods as originally proposed by Harrison and Zhang (1999).
TL;DR: In this article, the authors measure the systemic risk of a banking sector as a hypothetical distress insurance premium, identifies various sources of financial instability, and allocates systemic risk to individual financial institutions.
TL;DR: In this article, the authors argue that the remarkable success of today's financial risk management methods should be attributed primarily to their communicative and organizational usefulness and less to the accuracy of the results they produced.
Abstract: Is the growth of modern financial risk management a result of the accuracy and reliability of risk models? This paper argues that the remarkable success of today’s financial risk management methods should be attributed primarily to their communicative and organizational usefulness and less to the accuracy of the results they produced. This paper traces the intertwined historical paths of financial risk management and financial derivatives markets. Spanning from the late 1960s to the early 1990s, the paper analyses the social, political and organizational factors that underpinned the exponential success of one of today’s leading risk management methodologies, the applications based on the Black–Scholes–Merton options pricing model. Using primary documents and interviews, the paper shows how financial risk management became part of central market practices and gained reputation among the different organisational market participants (trading firms, the options clearinghouse and the securities regulator). Ultimately, the events in the aftermath of the market crash of October 1987 showed that the practical usefulness of financial risk management methods overshadowed the fact that when financial risk management was critically needed the risk model was inaccurate.
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19 Oct 2009TL;DR: In this paper, the authors provide a characterization theorem for coherent risk measures in the context of stochastic dominance tests, which are used to test whether a risk measure is consistent with the mean-variance rule.
Abstract: Utility in Decision Theory Choice under certainty Basic probability background Choice under uncertainty Utilities and risk attitudes Foundations of Stochastic Dominance Some preliminary mathematics Deriving representations of preferences Stochastic dominance (SD) Issues in Stochastic Dominance A closer look at the mean-variance rule Multivariate SD Stochastic dominance via quantile functions Financial Risk Measures The problem of risk modeling Some popular risk measures Desirable properties of risk measures Choquet Integrals as Risk Measures Extended theory of measures Capacities The Choquet integral Basic properties of the Choquet integral Comonotonicity Notes on copulas A characterization theorem A class of coherent risk measures Consistency with SD Foundational Statistics for Stochastic Dominance From theory to applications Structure of statistical inference Generalities on statistical estimation Nonparametric estimation Basics of hypothesis testing Models and Data in Econometrics Justifications of models Coarse data Modeling dependence structure Some additional statistical tools Applications to Finance Diversification Diversification on convex combinations Prospect and Markowitz SD Market rationality and efficiency SD and rationality of momentum effect Applications to Risk Management Measures of profit/loss for risk analysis REITs and stocks and fixed-income assets Evaluating hedge funds performance Evaluating iShare performance Applications to Economics Indifference curves/location-scale (LS) family LS family for n random seed sources Elasticity of risk aversion and trade Income inequality Appendix: Stochastic Dominance Tests Bibliography Index Exercises appear at the end of each chapter.
TL;DR: In this paper, the authors examined the incidence of operational losses among U.S. financial institutions using publicly reported loss data from 1980 to 2005 and found that most operational losses can be traced to a breakdown of internal control, and that firms suffering from these losses tend to be younger, more complex and have higher credit risk, more antitakeover provisions, and CEOs with higher stock option holdings and bonuses relative to salary.
Abstract: We examine the incidence of operational losses among U.S. financial institutions using publicly reported loss data from 1980 to 2005. We show that most operational losses can be traced to a breakdown of internal control, and that firms suffering from these losses tend to be younger, more complex, and have higher credit risk, more antitakeover provisions, and CEOs with higher stock option holdings and bonuses relative to salary. These findings highlight the correlation between operational risk and credit risk, as well as the role of corporate governance and proper managerial incentives in mitigating operational risk.
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TL;DR: In this paper, the authors present a comprehensive review of the extensive existing empirical literature that has tested these theories, documenting overall mixed empirical support for rationales of hedging with derivatives at the firm level.
Abstract: According to financial theory, corporate hedging can increase shareholder value in the presence of capital market imperfections such as direct and indirect costs of financial distress, costly external financing, and taxes. This paper presents a comprehensive review of the extensive existing empirical literature that has tested these theories, documenting overall mixed empirical support for rationales of hedging with derivatives at the firm level. While various empirical challenges and limitations advise some caution with regard to the interpretation of the existing evidence, the results are, however, consistent with derivatives use being just one part of a broader financial strategy that considers the type and level of financial risks, the availability of risk-management tools, and the operating environment of the firm. In particular, recent evidence suggests that derivatives use is related to debt levels and maturity, dividend policy, holdings of liquid assets, and the degree of operating hedging. Moreover, corporations do not just use financial derivatives, but rely heavily on pass-through, operational hedging, and foreign currency debt to manage financial risk.
TL;DR: The authors provided empirical evidence that sheds new light into the dynamic interactions between risk and efficiency, a highly debated issue, by employing a directional distance function framework, along with a cost frontier and a profit function.
Abstract: This paper provides empirical evidence that sheds new light into the dynamic interactions between risk and efficiency, a highly debated issue. First, we estimate three alternative measures of bank performance, by employing a directional distance function framework, along with a cost frontier and a profit function. As a second step, we calculate a Merton-type bank default risk. Then, we employ a panel VAR analysis, which allows the examination of the underlying relationships between efficiency and risk without applying any a priori restrictions. Most evidence shows that the effect of a one standard deviation shock of the distance to default on inefficiency is negative and substantial. There is some evidence of a reverse causation. As part of a sensitivity analysis, we extent our study to investigate the relationship between efficiency and default risk for banks with different types of ownership structures and across financial systems with different levels of development.
TL;DR: In this article, the authors use the euro area financial accounts (flow of funds) data to construct a sector-level network of bilateral balance sheet exposures and show how local shocks can propagate throughout the network and affect the balance sheets in other, even seemingly remote, parts of the financial system.
Abstract: The financial crisis has highlighted the need for models that can identify counter-party risk exposures and shock transmission processes at the systemic level. We use the euro area financial accounts (flow of funds) data to construct a sector-level network of bilateral balance sheet exposures and show how local shocks can propagate throughout the network and affect the balance sheets in other, even seemingly remote, parts of the financial system. We then use the contingent claims approach to extend this accounting-based network of interlinked exposures to risk-based balance sheets which are sensitive to changes in leverage and asset volatility. We conclude that the bilateral cross-sector exposures in the euro area financial system constitute important channels through which local risk exposures and balance sheet dislocations can be transmitted, with the financial intermediaries playing a key role in the processes. High financial leverage and high asset volatility are found to increase a sector’s vulnerability to shocks and contagion.
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TL;DR: In this paper, the authors developed a quantitative model of debt and default for small open economies that interact with risk averse international investors and showed that if investors have DARA preferences, then the emerging economy's default risk, capital flows, bond prices and consumption are a function not only of the fundamentals of the economy, but also of the level of financial wealth and risk aversion of the international investors.
Abstract: This paper develops a quantitative model of debt and default for small open economies that interact with risk averse international investors. The model developed here extends the recent work on the analysis of endogenous default risk to the case in which international investors are risk averse agents with decreasing absolute risk aversion (DARA). By incorporating risk averse investors who trade with a single emerging economy, the present model o ers two main improvements over the standard case of risk neutral investors: i.) the model exhibits a better fit of debt-to-output ratio and ii.) the model explains a larger proportion and volatility of the spread between sovereign bonds and riskless assets. The paper shows that if investors have DARA preferences, then the emerging economy’s default risk, capital flows, bond prices and consumption are a function not only of the fundamentals of the economy—as in the case of risk neutral investors—but also of the level of financial wealth and risk aversion of the international investors. In particular, as investors become wealthier or less risk averse, the emerging economy becomes less credit constrained. As a result, the emerging economy’s default risk is lower, and its bond prices and capital inflow are higher. Additionally, with risk averse investors, the risk premium in the asset prices of the sovereign countries can be decomposed into two components: a base premium that compensates the investors for the probability of default (as in the risk neutral case) and an “excess” premium that compensates them for taking the risk of default.
01 Jan 2009
TL;DR: Results suggest that events detected in news can be used advantageously as supplementary parameters in financial applications, and a competitive, knowledge-driven, semi-automatic system for financial event extraction from text is presented.
Abstract: markdownToday’s financial markets are inextricably linked with financial events like acquisitions, profit announcements, or product launches. Information extracted from news messages that report on such events could hence be beneficial for financial decision making. The ubiquity of news, however, makes manual analysis impossible, and due to the unstructured nature of text, the (semi-)automatic extraction and application of financial events remains a non-trivial task. Therefore, the studies composing this dissertation investigate 1) how to accurately identify financial events in news text, and 2) how to effectively use such extracted events in financial applications.
Based on a detailed evaluation of current event extraction systems, this thesis presents a competitive, knowledge-driven, semi-automatic system for financial event extraction from text. A novel pattern language, which makes clever use of the system’s underlying knowledge base, allows for the definition of simple, yet expressive event extraction rules that can be applied to natural language texts. The system’s knowledge-driven internals remain synchronized with the latest market developments through the accompanying event-triggered update language for knowledge bases, enabling the definition of update rules.
Additional research covered by this dissertation investigates the practical applicability of extracted events. In automated stock trading experiments, the best performing trading rules do not only make use of traditional numerical signals, but also employ news-based event signals. Moreover, when cleaning stock data from disruptions caused by financial events, financial risk analyses yield more accurate results. These results suggest that events detected in news can be used advantageously as supplementary parameters in financial applications.
TL;DR: This article examined the impact of mergers on default risk and found that, on average, a merger increases the default risk of the acquiring firm, and that the increased default risk may arise from aggressive managerial actions affecting risk enough to outweigh the strong risk reducing asset diversification expected from a typical merger.
Abstract: We examine the impact of mergers on default risk. Despite the potential for asset diversification, we find that, on average, a merger increases the default risk of the acquiring firm. This result cannot solely be explained by the tendency for generally safe acquirers to purchase riskier targets or by the tendency of acquiring firms to increase leverage post-merger. Our evidence suggests that manager-related issues may play an important role. In particular, we find larger merger-related increases in risk at firms where CEOs have large option-based compensation, where recent stock performance is poor, and where idiosyncratic equity volatility is high. These results suggest that the increased default risk may arise from aggressive managerial actions affecting risk enough to outweigh the strong risk-reducing asset diversification expected from a typical merger.
TL;DR: Using the Fama-French three factor model, the cost of drug development is found to be higher than the earlier estimate, and the authors' base case estimate was $802 million.
Abstract: In a widely cited article, DiMasi, Hansen, and Grabowski (2003) estimate the average pre-tax cost of bringing a new molecular entity to market. Their base case estimate, excluding post-marketing studies, was $802 million (in $US 2000). Strikingly, almost half of this cost (or $399 million) is the cost of capital (COC) used to fund clinical development expenses to the point of FDA marketing approval. The authors used an 11% real COC computed using the capital asset pricing model (CAPM). But the CAPM is a single factor risk model, and multi-factor risk models are the current state of the art in finance. Using the Fama-French three factor model we find that the cost of drug development to be higher than the earlier estimate.
TL;DR: In this paper, a comparative economic analysis of the costs and benefits of alternative default risk sharing mechanisms casts considerable doubt on the advisability of central clearing of credit derivatives, and although regulators have argued that clearing would reduce systemic risk, a more complete analysis demonstrates that clearing could actually increase risks to the broader financial system.
Abstract: Credit derivatives have received intense scrutiny -- and criticism -- as a major contributor to the ongoing financial crisis. In response, regulators have proposed requiring the formation of a central clearinghouse to share default risk on these contracts. A comparative economic analysis of the costs and benefits of alternative default risk sharing mechanisms casts considerable doubt on the advisability of central clearing of credit derivatives. These products are likely to be subject to severe information asymmetry problems regarding their value, risk, and the creditworthiness of those who trade them, and these information asymmetries are likely to be less severe in bilateral markets than in centrally cleared systems. Moreover, although regulators have argued that clearing would reduce systemic risk, a more complete analysis demonstrates that clearing could actually increase risks to the broader financial system.
TL;DR: In this paper, a qualitative study with 150 UK mortgage holders to assess the character, extent and possible mitigation of wider risk regime for home ownership and risk has focused on the management of mortgage debt, but there are other risks for home buyers in settings where housing dominates people's wealth portfolios.
Abstract: Most debate on home ownership and risk has focused on the management of mortgage debt. But there are other risks for home buyers in settings where housing dominates people's wealth portfolios: where the investment dimensions of property are at a premium; and where housing wealth is, de facto, an asset base for welfare. This article draws from qualitative research with 150 UK mortgage holders to assess the character, extent and possible mitigation of this wider risk regime. The analysis first explores the value home buyers attach to the financial returns on housing. Next we document the extent to which home equity is earmarked and used as a financial buffer. Finally, reflecting on the merits and limitations of this tactic, we conclude by asking whether – in the interests of housing and social policy, as well as with a view to managing the economy – there is any need, scope or appetite for more actively sharing the financial risks and investment gains of housing systems anchored on owner-occupation.
TL;DR: The authors employ a forensic analysis of the development of the subprime market from the 1980s through 2007 to argue that, in a competitive environment marked by the greater integration between housing finance and capital/equity markets, financial innovations provide new opportunities to hedge risk even as they collapse the barriers to rivalries between firms.
Abstract: Whereas policy makers and industry advocates have hailed the growth of the subprime mortgage market in the US as evidence that financial innovation can more efficiently price and absorb credit risk, the 2007 mortgage crisis provides an opportunity to revisit the nature of financial risk. This paper employs a forensic analysis of the development of the subprime market from the 1980s through 2007 to argue that, in a competitive environment marked by the greater integration between housing finance and capital/equity markets, financial innovations provide new opportunities to hedge risk even as they collapse the barriers to rivalries between firms. This has changed the terrain for risk assessment, promoting new modes of financial competition that have intensified systemic risk and extended it to a widening set of firms, households, and communities.
TL;DR: In this paper, the authors provided insights on the Financial Risk Management Disclosure (FRMD) patterns of Australian listed resource companies for the 2002-2006 period leading up to and immediately following adoption of the International Financial Reporting Standards (IFRS).
Abstract: This study provides insights on the Financial Risk Management Disclosure (FRMD) patterns of Australian listed resource companies for the 2002–2006 period leading up to and immediately following adoption of the International Financial Reporting Standards (IFRS). Regression analysis demonstrates that corporate governance and capital raisings of firms are significant and positively associated with FRMD patterns. In contrast, overseas stock exchange listing of firms is significantly negatively associated with FRMD patterns. The findings show that the introduction of IFRS changes corporation’s willingness to communicate risk information.
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TL;DR: In this paper, the authors focus on financial interlinkages within Europe and potential contagion channeled through these inter-linkages, and assess the magnitude of cross-border exposures between emerging and western European countries based on the stylized facts on these exposures.
Abstract: This paper focuses on financial interlinkages within Europe and potential contagion channeled through these interlinkages. It discusses the increased role of external financing as a source of funding for credit growth; analyzes potential channels of contagion through financial linkages; and assesses the magnitude of cross-border exposures between emerging and western European countries. Based on the stylized facts on these exposures, the paper provides simple indices of exposure to regional contagion that could help identify the likely pressure points and capture potential spillover effects and propagation channels of a regional shock originating from a given country.
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18 Dec 2009
TL;DR: The media's role in public policy formation and evaluation is discussed in this article, where Quixotics Unite! is proposed as a call to arms for the media to unite.
Abstract: Contents: Preface Introduction Luck, risk, and life chances The natural lottery and our genetic endowments Rational discrimination Markets that matter Financial risk and insurance The criminal justice system Public policy formation and evaluation The media's role "Quixotics Unite!" A call to arms Bibliography Index
TL;DR: The role of systemic risk in the recent financial crisis was examined in this article, which concluded that the economy could benefit from reforms that reduce systemic risks, such as the creation of an improved regime for resolving failures of large financial firms.
Abstract: How did problems in a relatively small portion of the home mortgage market trigger the most severe financial crisis in the United States since the Great Depression? Several developments played a role, including the proliferation o f complex mortgage-backed securities and derivatives with highly opaque structures, high leverage, and inadequate risk management. These, in turn, created systemic risk—that is, the risk that a triggering event, such as the failure of a large financial firm, will seriously impair financial markets and harm the broader economy. This article examines the role of systemic risk in the recent financial crisis. S ystemic concerns prompted the Federal Reserve and U.S. Department of the Treasury to act to prevent the bankruptcy of several large financial firms in 2008. The authors explain why the failures of financial firms are more likely to pose systemic risks than the failures of nonfinancial firms and discuss possible remedies for such risks. They conclude that the economy could benefit from reforms that reduce systemic risks, s uch as the creation of an improved regime for resolving failures of large financial firms. (JEL E44, E58, G01, G21, G28)
TL;DR: In this article, the authors argue that macro-prudential regulation is necessary to address the systemic risk inherent to ratings, and suggest the use of "ratings maps" and stress-tests to assess the systemic risks of ratings and increased capital or liquidity buffers to manage such risk.
Abstract: Credit ratings have contributed to the current financial crisis. Proposals to regulate credit rating agencies focus on micro-prudential issues and aim at reducing conflicts of interest and increasing transparency and competition. In contrast, this paper argues that macro-prudential regulation is necessary to address the systemic risk inherent to ratings. The paper illustrates how financial markets have increasingly relied on ratings. It shows how downgrades have led to systemic market losses and increased illiquidity. The paper suggests the use of “ratings maps” and stress-tests to assess the systemic risk of ratings, and increased capital or liquidity buffers to manage such risk.