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Preemptive Strategies for the Assessment and Management of Financial System Risk Levels: An Application to Japan with Implications for Emerging Economies
Abstract
We estimate the current potential default cost of the large amount of bad loans in the Japanese banking system to fail to range from 30 trillion yen to 45 trillion yen or higher. For many banks this would deplete at least 50% of their capital. However, it would also fix the loss and avoid potentially larger losses if weak credits continue to be supported. Using a simulation methodology, we also find that the assumed level of credit risk, equity investment, bank operating expenses, bank net interest margin, and the assumed future financial environments interact to determine future bank risk levels. If the negative financial and real estate market conditions of the recent past persist over the next three years, it is very likely that the major Japanese banks will suffer further large losses and exhaust their already low levels of capital. Alternatively, a return to a more positive economic and financial environment would moderate the risks and the cost of resolving the current problems. Nevertheless, under both 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. The implications of this analysis for emerging economies, center on the management and regulation of financial institutions in countries where financial market regulatory structures are in a state of change and asset price bubbles also occur.
... Simulation modeling can essentially match any assumed volatility and correlation structure for important financial environment variables (e.g. interest rates, FX rates, returns on corporate equities, returns on real estate assets, etc.). Earlier work on U.S. bond portfolios (Barnhill and Maxwell 2000), South African banks (Barnhill, Papapanagiotou, and Schumacher 2000), and Japanese Banks (Barnhill, Papapanagiotou, and Souto 2001) has shown that bank capital levels appropriate for reducing the risk of failure to a given probability over a given time step are related to: @BULLET the volatility of the financial environments in which banks operate, @BULLET the correlations between important financial market variables, @BULLET the mean returns on important financial market variables (e.g. real estate), @BULLET the distribution of credit qualities in the bank's loan portfolio, @BULLET the diversification of the loan portfolio across types of loans (business loans, residential mortgage loans, commercial mortgage loans, etc.), @BULLET the diversification of the business loan portfolio across sectors of the economy (e.g. ...
... Pillar 3 (Market Discipline) is generally well conceived and has the potential to be of significant value. Our comments will focus on a comparative analysis of the data needed to undertake integrated bank risk assessments and systemic risk analyses along the lines developed by Barnhill, et al ( , 2001) with that proposed in the new Basel Capital Accord. We will also suggest a split in reporting requirements between banks, and other parties (e.g. bank regulatory authorities, multi-lateral financial organizations, data vendors, etc.). ...
undertaking this study. The risk analyses were undertaken with the use of the ValueCalc software package developed by Professor Barnhill. 2 Synopsis This comment compares 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 banks. Under lower volatility (e.g. U.S.) financial market conditions the New Basel Capital Accord generally produces required capital adequate to protect against bank failure with a ninety-nine percent probability over a one-year time step. It is found that the simulated and Basel capital requirements are frequently close. However for banks with lower credit risk operating in lower volatility environments the Basel capital requirements generally appear to be to high. Alternatively for other banks with higher credit risk and concentrated portfolios the Basel capital requirements are too low, particularly so for those operating in higher volatility environments (e.g. emerging markets). It is shown that due to correlated interest rate and credit risk positive (negative) asset/liability maturity gaps likely increase (decrease) a bank's risk of failure. Recommendations focus on the crucial importance of continuing work to develop conceptual frameworks for undertaking integrated risk assessments and ad hoc improvements to the current proposals.
Banks are exposed to different types of risks in the process of financial intermediation and maturity transformation. The experience of the extant global financial crisis provided ample evidence of interaction among bank risks and perils of ignoring interactions in the changing economic, technological and regulatory environment. In this study, we assess the dynamic interaction among bank risks for the entire banking sector and bank groups based on various bank-specific characteristics in a vector autoregression framework, including variance decomposition and impulse response function analysis. We estimate the market measures of different risks using a multivariate GARCH (1, 1) in mean model. The study uses weekly bank level data from 23 October 2004 to 1 August 2014 for 40 listed Indian banks. The findings suggest that there is a positive interaction between equity risk and all other risks. Credit risk and exchange rate risk have a reciprocal relationship. It has also been observed that equity risk impacts credit risk positively. Interest rate risk seems to be affected by its lagged values and does not appear to be affected by other risks. The study highlights the role of liquidity in reducing bank risk exposures and supports new liquidity standards introduced in Basel III. The results improve the understanding of the interaction among risk exposures, which may enhance the supervisory process in the Basel framework. The risk interactions must be kept in mind for making capital provisioning, and an integrated approach to risk management by banks is more desirable.
In this study we present a comprehensive forward-looking portfolio simulation methodology for assessing the correlated impacts of market risk, private sector and Sovereign credit risk, and inter-bank default risk. In order to produce better integrated risk assessment for banks and systemic risk assessments for financial systems, we argue that reasonably detailed modeling of bank asset and liability structures, loan portfolio credit quality, and loan concentrations by sector, region and type, as well as a number of financial and economic environment risk drivers, is required. Sovereign and inter-bank default risks are increasingly important in the current economic environment and their inclusion is an important model extension. This extended model is demonstrated through an application to both individual Brazilian banks (i.e., 28 of the largest banks) and groups of banks (i.e., the Brazilian banking system) as of December 2004. When omitting Sovereign risk, our analysis indicates that none of the banks face significant default risk over a 1-year horizon. This low default risk stems primarily from the large amount of government securities held by Brazilian banks, but also reflects the banks' adequate capitalizations and extraordinarily high interest rate spreads. We note that none of the banks which we modeled failed during the very stressful 2007-2008 period, consistent with our results. Our results also show that a commonly used approach of aggregating all banks into one single bank, for purposes of undertaking a systemic banking system risk assessment, results in a misestimate of both the probability and the cost of systemic banking system failures. Once Sovereign risk is considered and losses in the market value of government securities reach 10% (or higher), we find that several banks could fail during the same time period. These results demonstrate the well known risk of concentrated lending to a borrower, or type of borrower, which has a non-zero probability of default (e.g., the Government of Brazil). Our analysis also indicates that, in the event of a Sovereign default, the Government of Brazil would face constrained debt management alternatives. To the best of our knowledge no one else has put forward a systematic methodology for assessing bank asset, liability, loan portfolio structure and correlated market and credit (private sector, Sovereign, and inter-bank) default risk for banks and banking systems. We conclude that such forward-looking risk assessment methodologies for assessing multiple correlated risks, combined with the targeted collection of specific types of data on bank portfolios, have the potential to better quantify overall bank and banking system risk levels, which can assist bank management, bank regulators, Sovereigns, rating agencies, and investors to make better informed and proactive risk management and investment decisions.
This paper models the effect of bank competition and deposit insurance premiums on the spread between lending and deposit rates. In developing economies, low spreads do not always indicate bank efficiency; they may be the result of high risk taking. This paper shows that imposing upper and lower limits on banks' spreads and adjusting deposit insurance premiums when violation of these limits occurs leads to a more stable but relatively large intermediation costs. In developing economies, such an outcome would be considered more desirable because it insulates existing financial intermediaries and investors against macroeconomic disturbances.
This paper compares different approaches to developing arbitrage-free models of the term structure. It presents a numerical procedure that can be used to construct a wide range of one-factor models of the short rate that are both Markov and consistent with the initial term structure of interest rates.
This article shows that the one-state-variable interest-rate models of Vasicek (1977) and Cox, Ingersoll, and Ross (1985b) can be extended so that they are consistent with both the current term structure of interest rates and either the current
volatilities of all spot interest rates or the current volatilities of all forward interest rates. The extended Vasicek model
is shown to be very tractable analytically. The article compares option prices obtained using the extended Vasicek model with
those obtained using a number of other models.
Even with hindsight, the ability to explain stock price changes is modest. R 2s were calculated for the returns of large stocks as explained by systematic economic influences, by the returns on other stocks in the same industry, and by public firm‐specific news events. The average adjusted R 2 is only about .35 with monthly data and .20 with daily data. There is little relation between explanatory power and either the firm's size or its industry. There is little improvement in R 2 from eliminating all dates surrounding news reports in the financial press. However, the sample kurtosis is quite different when such news events are eliminated, thereby revealing a mixture of return distributions. Non‐news dates also indicate the presence of a distributional mixture, perhaps due to traders acting on private information.
ABSTRACT Two easily measured variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with market {3, size, leverage, book-to-market equity, and earnings-price ratios. Moreover, when the tests allow for variation in {3 that is unrelated to size, the relation between market {3 and average return is flat, even when {3 is the only explanatory variable. THE ASSET-PRICING MODEL OF Sharpe (1964), Lintner (1965), and Black (1972)
Current risk assessment methodologies separate the analysis of market and credit risk and thus misestimate security and portfolio risk levels. We propose a new approach that relates financial market volatility to firm specific credit risk and integrates interest rate, interest rate spread, and foreign exchange rate risk into one overall fixed income portfolio risk assessment. Accounting for the correlation between these significant risk factors as well as portfolio diversification results in improved risk measurement and management. The methodology is shown to produce reasonable credit transition probabilities, prices for bonds with credit risk, and portfolio value-at-risk measures.
A theme of Japan’s banking problems in the 1990s was the consistently inadequate disclosure of the scale of bad loans outstanding.
The major banks began publishing outstanding loans to bankrupt and 60-day-overdue borrowers in 1993. By March 1995, this amount
stood at ¥12.5 trillion, or 3.3% of all loans (Figure 6.1).
Determinants of the aggregate default rate on high-yield bonds have been of interest at least since 1990 - 1991, when the proportion of defaulting issued reached effectively its highest level since the Great Depression. With recovery by the mid-19902, and a new record volume of issuance in 1993, analysts have wondered whether another wave of financial failures will follow. This research shows that nominal interest rates are not highly correlated with aggregate default rates on high-yield bonds. Real rates, however, significantly enhance analysts' ability to explain default rates. The effect is lagged by two years' meaning that investors can estimate future credit experience fairly accurately without having unique insights into the direction of the economy or financial markets.
The banking crises of the ‘90s emphasize the need to model the connections between financial environment volatility and the potential losses faced by financial institutions resulting from correlated market and credit risks. Due to the number of variables that must be modeled and the complexity of the relationships an analytical solution is not feasible. We present here a numerical solution based on a simulation model that explicitly links changes in the relevant variables that characterize the financial environment and the distribution of possible future bank capital ratios. This forward looking quantitative risk assessment methodology allows banks and regulators to identify potential risks before they materialize and make appropriate adjustments to bank portfolio credit qualities, sector and region concentrations, and capital ratios on a bank by bank basis. It also has the potential to be extended so as to assess the risks of correlated failures among a group of financial institutions (i.e., systemic risk analyses). This model was applied by the authors to the study of the risk profile of the largest South African Banks in the context of the Financial System Stability Assessment program undertaken by the IMF in 1999.
In the current study, we apply the model to various hypothetical banks operating in the South African financial environment and assess the correlated market and credit risks associated with business lending, mortgage lending, asset and liability maturity matches, foreign lending and borrowing, and direct equity, real estate, and gold investments. It is shown to produce simulated financial environments (interest rates, exchange rates, equity indices, real estate price indices, commodity prices, and economic indicators) that match closely the assumed parameters, and generate reasonable credit transition probabilities and security prices. As expected, the credit quality and diversification characteristics of the loan portfolio, asset and liability maturity mismatches, and financial environment volatility, are shown to interact to determine bank risk levels.
We find that the credit quality of a bank's loan portfolio is the most important risk factor. We also show the risk reduction benefits of diversifying the loan portfolio across various sectors and regions of the economy and the importance of accounting for volatility shocks that occur periodically in emerging economies. Banks with high credit risk and concentrated portfolios are shown to have a high risk of failure during periods of financial stress. Alternatively, banks with lower credit risk and broadly diversified loan portfolios across business and mortgage lending are unlikely to fail even during very volatile periods. Asset and liability maturity mismatches generally increase bank risk levels. However, because credit losses are positively correlated with interest rate increases, banks with high credit risk may reduce overall risk levels by holding liabilities with longer maturities than their assets. Risk assessment methodologies which measure market and credit risk separately do not capture these various interactions and thus misestimate overall risk levels.
Testing the two-parameter asset pricing theory is difficult (and currently infeasible). Due to a mathematical equivalence between the individual return/‘beta’ linearity relation and the market portfolio's mean-variance efficiency, any valid test presupposes complete knowledge of the true market portfolio's composition. This implies, inter alia, that every individual asset must be included in a correct test. Errors of inference inducible by incomplete tests are discussed and some ambiguities in published tests are explained.
We develop evidence on the finite sample properties of the Generalized Method of Moments (GMM) in an asset pricing context. The models imply nonlinear, cross-equation restrictions on predictive regressions for security returns. We find that a two-stage GMM approach produces goodness-of-fit statistics that reject the restrictions too often. An iterated GMM approach has superior finite sample properties. The coefficient estimates are approximately unbiased in simpler models, but their asymptotic standard errors are understated. Simple adjustments for the standard errors are partially successful in correcting the bias. In more complex models the coefficients and their standard errors can be highly unreliable. The power of the tests to reject a single-premium model is higher against a two-premium, fixed-beta alternative than against a conditional Capital Asset Pricing Model with time-varying betas.
Mayers and Rice do not resolve the basic problem in portfolio performance evaluation with the securities market line, the ambiguity introduced by being obliged to choose a market index. Other performance evaluation techniques exist and possess some superior qualities. The Mayers-Rice discussion of my critique of the capital asset pricing model (CAPM) fails to recognize the CAPM's unusual testing implications and ignores the existence of alternative asset pricing theories. Residual analysis should give approximately correct estimates of the abnormal returns caused by specific events if it is conducted with the market model.
This paper suggests that it is not possible to demonstrate, using the best available empirical methods, that the expected returns on high yield common stocks differ from the expected returns on low yield common stocks either before or after taxes. A taxable investor who concentrates his portfolio in low yield securities cannot tell from the data whether he is increasing or decreasing his expected after-tax return by so doing. A tax exempt investor who concentrates his portfolio in high yield securities cannot tell from the data whether he is increasing or decreasing his expected return. We argue that the best method for testing the effects of dividend policy on stock prices is to test the effects of dividend yield on stock returns. Thus the fact that we cannot tell, using the best available methods, what effects dividend yield has on stock returns implies that we cannot tell what effect, if any, a change in dividend policy will have on a corporation's stock price.
This paper proposes tests of asset pricing models that allow for time variation in conditional covariances. The evidence indicates that the conditional covariances do change through time. Estimates of the expected excess return on the market divided by the variance of the market (reward-to-risk ratio) are presented for the Sharpe-Lintner CAPM, as well as a number of tests of the model specification. The patterns of the pricing errors through time suggest the model's inability to capture the dynamic behavior of assets returns.
This paper uses a VAR to investigate four possible explanations of the extended slump in Japanese economic activity over the 1990s: the absence of bold and consistent fiscal stimulus; the limited room for expansionary monetary policy due to a liquidity trap; overinvestment and debt overhang; and disruption of financial intermediation. The results indicate that all of these factors played a role, but that the major explanation is disruption in financial intermediation, largely operating through the impact of changes in domestic asset prices on bank lending.
The capital asset pricing model provides a theoretical structure for the pricing of assets with uncertain returns. The premium to induc e risk-averse investors to bear risk is proportional to the nondivers ifiable risk, which is measured by the covariance of the asset return with the market portfolio return. In this paper, a multivariate, gen eralized-autoregressive, conditional, heteroscedastic process is esti mated for returns to bills, bonds, and stocks where the expected retu rn is proportional to the conditional covariance of each return with that of a fully diversified or market portfolio. It is found that the conditional covariances are quite variable over time and are a signi ficant determinant of the time-varying risk premia. The implied betas are also time varying and forecastable. Copyright 1988 by University of Chicago Press.
If options are correctly priced in the market, it should not be possible to make sure profits by creating portfolios of long and short positions in options and their underlying stocks. Using this principle, a theoretical valuation formula for options is derived. Since almost all corporate liabilities can be viewed as combinations of options, the formula and the analysis that led to it are also applicable to corporate liabilities such as common stock, corporate bonds, and warrants. In particular, the formula can be used to derive the discount that should be applied to a corporate bond because of the possibility of default.
We argue that the deregulation leading up to the Big Bang has played a major role in the current banking problems. This deregulation allowed large corporations to quickly switch from depending on banks to relying on capital market financing. We present evidence showing that large Japanese borrowers, particularly manufacturing firms, have already become almost as independent of banks as comparable U.S. firms. The deregulation was much less favorable for savers and consequently they mostly continued turning their money over to the banks. However, banks were also constrained. They were not given authorization to move out of traditional activities into new lines of business. These developments together meant that the banks retained assets and had to search for new borrowers. Their new lending primarily flowed to small businesses and became much more tied to property than in the past. These loans have not fared well during the 1990s. We discuss the size of the current bad loans problem and conclude that it is quite large (on the order of 7% of GDP). Looking ahead, we argue that the Big Bang will correct the aforementioned regulatory imbalances. This will mean that banks will have to fight to retain deposits. More importantly, we expect even more firms to migrate to capital market financing. Using the U.S. borrowing patterns as a guide, we present estimates showing that this impending shift implies a massive contraction in the size of the Japanese banking sector.
The seeming failure of loose monetary policy to reactivate Japan's economy has led some observers to suggest that the usual credit channels through which monetary policy affects the real economy are blocked, and this is because of a pervasive shortage of bank capital that has induced a leftward shift in the supply of bank credit. This is the so-called capital crunch hypothesis. This paper finds support for the hypothesis in the bank data for 1997--a year during which the landscape of the Japanese financial system underwent some fundamental changes.
For a large part of the past decade, Japan has witnessed a steady deterioration in the health of its banking system. This paper examines what went wrong and why it has taken so long for the system to recover. While the paper traces the roots of the crisis to accelerated deregulation and deepening of capital markets without an appropriate adjustment in the regulatory framework, it identifies weak corporate governance and regulatory forbearance as the two factors behind what might have been an unnecessary prolongation of the distress of the financial system.
The dramatic 70 percent decline in Japanese commercial real estate prices from their peak in 1990 provides a natural experiment to test the extent to which a loan supply shock can affect real economic activity. Because the shock was external to U.S. credit markets, yet connected through the substantial penetration of U.S. lending markets by Japanese banks, this event allows us to identify an exogenous loan supply shock and ultimately link that shock to construction activity in major commercial real estate markets in the United States. We use panel data that exploit the variation across geographically distinct commercial real estate markets in the United States, both in degree of Japanese bank penetration and in local demand conditions, to establish conclusively that loan supply shocks emanating from loan problems in Japan had real effects on economic activity in the United States. Revised 1999.
Changes in variance, or volatility, over time can be modeled using the approach based on autoregressive conditional heteroscedasticity. Another approach is to model variance as an unobserved stochastic process. Although it is not easy to obtain the exact likelihood function for such stochastic variance models, they tie in closely with developments in finance theory and have certain statistical attractions. This article sets up a multivariate model, discusses its statistical treatment, and shows how it can be modified to capture common movements in volatility in a very natural way. The model is then fitted to daily observations on exchange rates.
In recent years, the number of downgrades in corporate bond ratings has exceeded the number of upgrades, leading some to conclude that the credit quality of U.S. corporate debt has declined. However, an alternative explanation of this apparent decline in credit quality is that the rating agencies are now using more stringent standards in assigning ratings. An ordered probit analysis of a panel of firms from 1978 through 1995 suggests that rating standards have indeed become more stringent, implying that at least part of the downward trend in ratings is the result of changing standards. Copyright The American Finance Association 1998.
Two easily measured variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with market "beta", size, leverage, book-to-market equity, and earnings-price ratios. Moreover, when the tests allow for variation in "beta" that is unrelated to size, t he relation between market "beta" and average return is flat, even when "beta" is the only explanatory variable. Copyright 1992 by American Finance Association.
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