the present practice of modeling market risk separately from credit risk, a simplification made for

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the present practice of modeling market risk
separately from credit risk, a simplification
made for expediency, is certainly questionable in
times of extraordinary market stress. Under
extreme conditions, discontinuous jumps in market
valuations raise the specter of insolvency, and
market risk becomes indistinct from credit
risk. Alan Greenspan, Chairman, Federal
Reserve Board May 4, 2000 Conference on Bank
Structure and Competition at Federal Reserve
Bank of Chicago
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Comments On The New Basel Capital Accord The
Crucial Importance of a Conceptual Framework

• Theodore M. Barnhill, Jr.
• Chairman, Department of Finance
• Director, Financial Markets Research Institute
• The George Washington University
• Katherine Gleason
• Ph.D. Candidate, Department of Finance
• Research Fellow, Financial Markets Research
  Institute
  
• The George Washington University

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Basel Synopsis

• We compare bank capital requirements estimated
  with an integrated market and credit risk
  simulation to those calculated under the 1988 and
  proposed new Basel Capital Accords for a set of
  hypothetical banks.

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Basel Synopsis

• This is accomplished by
• Simulating the future financial environment (e.g.
  1 year) as a set of correlated variables
  (interest rates, FX rates, equity indices, real
  estate price indices, inflation rate, etc.)
• Simulating the correlated evolution of the debt
  to value ratios and credit rating for each
  security in the portfolio as a function of the
  financial environment
• Revaluing each security in the portfolio as a
  function of the simulated financial environment
  and credit ratings (including default)
  
• Revaluing the total portfolio under the simulated
  conditions
  
• Repeating the simulation a large number of times
• Analyzing the distribution of simulated portfolio
  values to determine the risk levels
  

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Basel Synopsis

• Earlier work on modeling U.S. bond portfolios
  (Barnhill and Maxwell 2000) , and modeling South
  African Banks (Barnhill, Papapanagiotou, and
  Schumacher 2000) , show the following.
• The simulated financial environment matches
  closely the assumed parameters for the
  environmental variables.
  
• Simulated credit transition probabilities are
  similar to reported historical transition
  probabilities.
  
• Simulated prices of bonds with credit risk are
  close to observed market prices.
  
• Simulated value at risk measures for bond
  portfolios are very similar to historical value
  at risk measures.

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Basel Synopsis

• In the current work Simulated Bank Capital Ratios
  are driven by
  
• the mean return, volatility, and correlations of
  important financial market variables,
  
• the distribution of loan to value ratios and
  credit qualities in the bank's loan portfolio,
  
• the diversification of the business loan
  portfolio across sectors of the economy,
  
• the diversification of the mortgage loan
  portfolio across geographic regions,
  
• asset and liability maturity and currency
  mismatches,
  
• the amount and diversification of equity and
  other direct investments across sectors of the
  economy and regions of the country.
  

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Basel Synopsis

• We also generally find a negative correlation
  between interest rate changes and equity returns.
  This indicates that interest rate and business
  loan credit risk are also negatively correlated.
• Under such conditions the simulations indicate
  that positive (negative) asset/liability maturity
  gaps likely increase (decrease) a banks risk of
  failure. This occurs because in times of
  exceptionally high interest rates banks are
  likely to experience a correlated increase in
  credit losses.

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Recommendations

• We believe that development of an accepted
  conceptual framework(s) for undertaking
  integrated market and credit risk assessments is
  very important.

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Recommendations

• Pillar 1 (Minimum Capital Requirements)
• Until a generally accepted integrated risk
  assessment methodology has been developed,
  
• ad hoc adjustments to the proposed capital
  requirements should be considered to
  
• moderately reduce capital requirements for
  particularly low risk banks, and
  
• increase capital requirements for banks with
  multiple risk factors (e.g. volatile environment,
  high credit risk, concentrated portfolio)
  

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Recommendations

• Pillar 2 (Supervisory Review Process)
• In our view the supervisory review process should
  be a pro-active one where potential risks are
  identified and preemptive actions taken before
  the risks materialize.

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Recommendations

• Pillar 2 - Potential Preemptive Actions
• Governmental
• adopt monetary and economic polices that foster
  stable long-term economic growth.
  
• Banks or Bank Regulators
• change lending standards and credit quality of
  the portfolio
  
• change the level of direct equity and real estate
  investment
  
• change the sector and region concentration levels
  of the loan portfolio
  
• change the asset/liability maturity structure and
  currency structure
  
• change capital levels.

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Recommendations

• Pillar 3 (Market Discipline)
• Pillar 3 is generally well conceived and has the
  potential to be of significant value.
  
• We identify data requirements for undertaking an
  integrated market and credit risk analysis.
  
• We recommend that, in general, banks would be
  responsible for reporting required data on their
  portfolios, and others would be responsible for
  the data required to model the financial
  environment.

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Preemptive Strategies for the Assessment and
Management of Financial System Risk Levels an
Application to Japan with Implications for
Emerging EconomiesTheodore M. Barnhill,
Jr.Chairman, Department of Finance,
andDirector, Financial Markets Research
Institute (FMRI),The George Washington
UniversityPanagiotis Papapanagiotou, Research
FellowFinancial Markets Research Institute
(FMRI)The George Washington UniversityMarcos
Rietti Souto, Research Fellow (FMRI), andPh.D.
Candidate at Department of FinanceThe George
Washington University
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Japan Synopsis
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Japan Synopsis
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Japan Synopsis

• This study illustrates a forward looking
  asset/liability portfolio simulation methodology
  for modeling the connections between financial
  environment volatility (e.g. equity price, and
  real estate price) and the potential losses faced
  by banks due to correlated market and credit
  risk.
• Assessing correlated risks is particularly
  important for Japanese banks since they have
  large direct equity investments, and large
  amounts of both business loan and real estate
  mortgage credit risk.

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Japan Synopsis

• The future impact of these correlated risks is
  related significantly to current macro economic
  and monetary policy decisions. Of particular
  importance is the decision to re-inflate the
  economy or not.
• Bank operating expenses and net interest margin
  are also important variables in explaining
  differences in bank risk over time.

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Japan Synopsis

• We have received no input from Japanese banks or
  bank regulators.
  
• Analysis uses only publicly available data.
• Data limitations required a number of assumptions
  on
  
• Distribution of commercial and residential
  mortgage loan to value ratios,
  
• Typical loan to value ratios where non-recourse
  mortgage loans default,
  
• Typical recovery rates on mortgage loans, and
  business loans,
  
• Volatility of prices for individual real estate
  properties, etc.
  
• Thus our conclusions should be taken as
  illustrative not definitive.

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Japan Synopsis

• Surprisingly the recovery rate on defaulted
  commercial mortgage and business loans appears to
  be in the range of twenty to thirty percent.
  
• This very low recovery rate suggests a serious
  failure to take timely action to protect the
  interest of the banks. Likewise the public's
  interests may not have been well served by
  propping up weak credits since large amounts of
  additional public funding will likely be required
  to protect bank depositors from loss.

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Japan Synopsis

• We estimate that allowing the large amount of bad
  loans in the Japanese banking system to fail
  could deplete fifty to over one hundred percent
  of many banks capital. However it would also
  fix the loss and avoid potentially larger losses
  if weak credits continue to be supported.

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Japan Synopsis

• A continuation of the economic status quo, of low
  to negative inflation and declining assets
  values, is very likely to result in major
  Japanese banks suffering further large losses
  over the next several years and exhausting their
  already low levels of capital.

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Japan Synopsis

• A return to a more positive economic and
  financial environment, with moderate inflation
  and rising asset values, would reduce bank risk
  levels and the cost of resolving current
  problems.

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Japan Synopsis

• Under both economic scenarios the risk of further
  bank failures appears to be substantial and
  additional large capital infusions will likely be
  needed to avoid losses by depositors.

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Japan Synopsis

• There are no easy or cheap answers to resolving
  the Japanese financial crisis. The collapse of
  the real estate and equity price bubble of the
  late 1980s has simply left Japanese banks with
  too many bad loans secured by collateral with a
  low value.

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Modeling Japans Financial Environment

• We used fifty correlated random variables
• 8 domestic arbitrage-free term structures
  (AAA-CCC)
  
• 3 foreign interest rate arbitrage-free
  term-structures
  
• 3 foreign exchange rates
• 20 domestic equity market indices
• 10 regional commercial real estate price indices
• 10 regional residential real estate price
  indices
  
• SP 500 stock price index, the gold price, and
  the Japanese inflation rate

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Modeling Japans Financial Environment

• Two alternative future environments
• Positive (1987-1995) Higher economic growth,
  low inflation, and higher investor confidence.
  Higher mean returns, volatilities and
  correlations between changes in prices and other
  environmental variables.
• Negative (1996-2000) Inflation rates close to
  zero or below. Continued low economic growth
  rates and equity returns. Negative real estate
  returns. Lower asset return volatilities.

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Modeling Japanese Bank Asset and Liability
Portfolios

• We model a Set of Hypothetical Banks with balance
  sheets similar to the aggregate for City Banks,
  combined Trust and LTC Banks, Regional Banks, and
  Regional Tier-II Banks.
• Banks A/L portfolios are assumed to be constant
  over the horizon of the risk analysis. Their
  future values are estimated using the simulated
  financial environment and credit quality of the
  borrowers.

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Modeling Japanese Bank Asset and Liability
Portfolios

• For each of the hypothetical banks, approximately
  200 business loans, 200 mortgage loans
  (commercial and residential), 20 equity
  securities, and 20 real estate assets were used
  to model banks asset portfolio.
• The expense ratio (fee income plus other income
  less operating expenses divided by total assets)
  was used to estimate net operating income not
  accounted for by changes in the value of assets
  and liabilities.

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Summary and Conclusions

• Given their high levels of correlated equity
  price risk, business loan credit risk, and
  mortgage loan credit risk the value an integrated
  market and credit risk analysis is substantial
  for Japanese banks. This is particularly so
  because all of these risk will significantly
  affected by current monetary and economic policy
  decisions.
• Under the status quo it is very likely that the
  major Japanese banks will suffer further large
  losses and exhaust their current already low
  levels of capital over the next three years.
• Alternatively a return to more positive economic
  and financial market conditions, including in
  particular moderately increasing as opposed to
  sharply decreasing real estate and equity prices,
  would increase the chances of avoiding a major
  crisis and reduce the ultimate cost of resolving
  current problems.
• Nevertheless under both financial market
  scenarios the risk of further bank failures
  appears to be substantial.

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Summary and Conclusions

• Allowing particularly weak credits to fail and
  moving to protect any remaining value for loan
  collateral will likely reduce the long-term costs
  of resolving the crisis.
• However the risk of applying this strategy on a
  massive scale is that real estate and other asset
  values could be forced even lower in the short to
  medium term.
• In any event additional large capital infusions
  from the government will likely be required to
  avoid depositor losses.

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Summary and Conclusions

• In hindsight it seems obvious that everyone must
  keep in mind that asset prices that go up rapidly
  can also come down rapidly thereby creating bad
  loans.
• Actions which may be taken to protect banks,
  depositors, governments, and economies from such
  bubbles include
  
• adoption of economic polices which encourages
  sustainable long-term economic growth rates, and
  
• raising required loan to value ratios,
  diversifying portfolios, and increasing bank
  capital requirements during boom times.
  
• Efficient bank management (i.e. control of
  operating costs) and loan pricing (i.e.
  maintaining net interest margins adequate to more
  than cover credit costs) are of course always
  crucial to maintaining bank profitability and
  ultimately solvency.

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Summary and Conclusions

• It is important to understand that financial
  market liberalization offers both significant
  long-term benefits and, in many cases, major
  risks as institutions are required to adapt to a
  new competitive environment.
• Feasible and useful extensions of the study could
  include
  
• modeling specific banks, and
• Systemic risk analyses where multiple banks would
  be modeled simultaneously to assess the risk of
  correlated and perhaps cascading bank failures.

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Modeling the Financial Environment

• Simulating Interest Rates (Hull and White, 1994)
• Simulating Credit Spreads (Stochastic Lognormal
  Spread)
  
• Simulating Equity Indices and FX Rates (Geometric
  Brownian Motion)
  
• Simulating Multiple Correlated Stochastic
  Variables (White, 1997)

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Simulating the Return on Equity Indices and FX
Rates

• where
• S asset spot price S is assumed to follow
  
  
• geometric Brownian motion

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Credit Risk Simulation Methodology

• The conceptual basis is the Contingent Claims
  Analytical framework (Black, Scholes, Merton)
  where credit risk is a function of a firms
  
• Debt to Value ratio
• Volatility of firm value

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Credit Risk Simulation Methodology

• The following methodology is utilized to simulate
  business loan credit rating transitions
  
• Simulate the return on an equity market index
• Using either a one factor or multi-factor model
  simulate the return on equity for each firm
  included in the portfolio
  
• Calculate the firms simulated market value of
  equity
  
• Calculate the firms simulated debt ratio (i.e.
  total liabilities/total liabilities market
  value of equity)
  
• Map simulated debt to value ratios into simulated
  credit ratings

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Simulating the Equity Return of a Firm

• Once the market equity return is simulated, the
  return on equity for the individual firms are
  simulated using a one-factor model (multi-factor
  models could be used too)
• Ki RF Betai (Rm - RF) ?i?z
• Ki The return on equity for the firmi,
• RF the risk-free interest rate,
• Betai the systematic risk of firmi,
• Rm the simulated return on the equity index,
• ?i the firm specific volatility in return on
  equity,
  
• ?z a Wiener process with ?z being related to ?t
  
  
• by the function ?z ???t.

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Mapping Simulated Debt Ratios into Simulated Bond
Ratings

• Utilizing the simulated equity returns, simulated
  debt ratios are calculated and then mapped into
  simulated bond ratings

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