IFM Barnhill 06 12 2001

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Information about IFM Barnhill 06 12 2001
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Published on April 22, 2008

Author: Pumbaa

Source: authorstream.com

“…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 :  “…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:  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 Basel Synopsis:  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:  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 Basel Synopsis:  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. Basel Synopsis:  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. Basel Synopsis:  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 bank’s risk of failure. This occurs because in times of exceptionally high interest rates banks are likely to experience a correlated increase in credit losses. Recommendations:  Recommendations We believe that development of an accepted conceptual framework(s) for undertaking integrated market and credit risk assessments is very important. Recommendations:  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) Recommendations:  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. Recommendations:  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. Recommendations:  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. Preemptive Strategies for the Assessment and Management of Financial System Risk Levels: an Application to Japan with Implications for Emerging Economies Theodore M. Barnhill, Jr. Chairman, Department of Finance, and Director, Financial Markets Research Institute (FMRI), The George Washington University Panagiotis Papapanagiotou, Research Fellow Financial Markets Research Institute (FMRI) The George Washington University Marcos Rietti Souto, Research Fellow (FMRI), and Ph.D. Candidate at Department of Finance The George Washington University:  Preemptive Strategies for the Assessment and Management of Financial System Risk Levels: an Application to Japan with Implications for Emerging Economies Theodore M. Barnhill, Jr. Chairman, Department of Finance, and Director, Financial Markets Research Institute (FMRI), The George Washington University Panagiotis Papapanagiotou, Research Fellow Financial Markets Research Institute (FMRI) The George Washington University Marcos Rietti Souto, Research Fellow (FMRI), and Ph.D. Candidate at Department of Finance The George Washington University Japan Synopsis:  Japan Synopsis Japan Synopsis:  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 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. Japan Synopsis:  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:  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. Japan Synopsis:  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:  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:  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:  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. Japan Synopsis:  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:  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 Japan’s Financial Environment:  Modeling Japan’s 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 S&P 500 stock price index, the gold price, and the Japanese inflation rate Modeling Japan’s Financial Environment:  Modeling Japan’s 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 Portfolios:  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. Modeling Japanese Bank Asset and Liability Portfolios:  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 bank’s 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. Summary and Conclusions:  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. Summary and Conclusions:  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:  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. Summary and Conclusions:  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. Modeling the Financial Environment:  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) Simulating the Return on Equity Indices and FX Rates:  Simulating the Return on Equity Indices and FX Rates where S = asset spot price; S is assumed to follow geometric Brownian motion Credit Risk Simulation Methodology:  Credit Risk Simulation Methodology The conceptual basis is the Contingent Claims Analytical framework (Black, Scholes, Merton) where credit risk is a function of a firm’s: Debt to Value ratio Volatility of firm value Credit Risk Simulation Methodology:  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 firm’s simulated market value of equity Calculate the firm’s 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:  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. Mapping Simulated Debt Ratios into Simulated Bond Ratings:  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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