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


Simulated credit transition probabilities are similar to reported historical ... Simulated prices of bonds with credit risk are close to observed market prices. ... – PowerPoint PPT presentation

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

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
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
  • The George Washington University

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.

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
  • Repeating the simulation a large number of times
  • Analyzing the distribution of simulated portfolio
    values to determine the risk levels

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
  • 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.

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
  • 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.

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

  • 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)

  • 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.

  • 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
  • change the sector and region concentration levels
    of the loan portfolio
  • change the asset/liability maturity structure and
    currency structure
  • change capital levels.

  • 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

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
Japan Synopsis
Japan Synopsis
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
  • 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.

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.

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
  • 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.

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.

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.

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.

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

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.

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.

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

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.

Modeling Japanese Bank Asset and Liability
  • 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

Modeling Japanese Bank Asset and Liability
  • 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
  • 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.

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.

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
  • 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.

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
  • 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.

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

Simulating the Return on Equity Indices and FX
  • where
  • S asset spot price S is assumed to follow

  • geometric Brownian motion

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

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
  • 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

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
  • ?z a Wiener process with ?z being related to ?t

  • by the function ?z ???t.

Mapping Simulated Debt Ratios into Simulated Bond
  • Utilizing the simulated equity returns, simulated
    debt ratios are calculated and then mapped into
    simulated bond ratings

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