Bank Risk Exposure Research Articles

Regulation of Pension Fund Credit Risk: Lessons from the Banking Sector

This article examines the regulatory framework for managing the credit risk of pension funds in Brazil. We believe that the current framework is not very effective at controlling credit risk, and also overly limits the investment possibilities of pension fund managers. We consider the regulatory framework for banks as an alternative approach for future developments, and propose that the rules on credit risk exposure of pension funds and banks be made uniform. The resulting regulatory framework would be more effective and easy to monitor, facilitating the work of external supervision and auditing. Finally, we present a numerical example using real data on six Brazilian pension funds to illustrate the proposal.

Keiretsu and risk: An examination of the risk exposure of keiretsu banks in Japan

We compare risk positions adopted by keiretsu and non-keiretsu banks in Japan and examine how the risk positions of Japanese banks changed following the conclusion in 1997 of an escalating series of banking crises in Japan and East-Asia. The results indicate that keiretsu banks take less risk than non-keiretsu banks, and that Japanese banks in general adopted lower risk profiles after 1997. Japanese bank risk is positively associated with the ratio of non-performing loans to capital, interest rates, and private investment in residential construction, and negatively with the ratio of administrative expenses to average assets and the money supply

What Caused the Bank Capital Build-up of the 1990s?*

Large U.S. banks dramatically increased their capitalization during the 1990s, to the highest levels in more than 50 years. We document this buildup of capital and evaluate several potential motivations. Our results support the hypothesis that regulatory innovations in the early 1990s weakened conjectural government guarantees and enhanced the bank counterparties’ incentive to monitor and price default risk. We find no evidence that a bank holding company’s market capitalization increases with its asset volatility prior to 1994. Thereafter, the data display a strong cross-sectional relation between capitalization and asset risk. Our estimates indicate that most of the bank capital buildup over the sample period can be explained by greater bank risk exposures and the market's increased demand that large banks’ default risk be priced.

When risk premiums decrease as the bank's risk increases—a caveat on the use of subordinated bonds as an instrument of banking supervision

Many new proposals advocate the use of subordinated bonds in banking supervision. These proposals explicitly or implicitly assume that the prices and yields (i.e., risk premiums) of subordinated bonds are unbiased signals on the bank's risk exposure. We show that in general this assumption does not hold. In actuality, the risk premiums may decrease even as the bank's risk increases. This may also hold when the bank is solvent, that is, when total assets exceed total liabilities. This result occurs with both general density functions as well as the more positively skewed density functions that are intended to reflect the return of a bank's asset portfolio. As this distortion of market prices is more likely to occur with sufficiently large volume of subordinated debt, we advocate the implementation of an upper bound on subordinated debt—as a complement to the minimum level recommended by the literature.

What Caused the Bank Capital Build-up of the 1990s?

Large U.S. banks dramatically increased their capitalization during the 1990s, to the highest levels in more than 50 years. We document this buildup of capital and evaluate several potential motivations. Our results support the hypothesis that regulatory innovations in the early 1990s weakened conjectural government guarantees and enhanced the bank counterparties' incentive to monitor and price default risk. We find no evidence that a bank holding company's market capitalization increases with its asset volatility prior to 1994. Thereafter, the data display a strong cross-sectional relation between capitalization and asset risk. Our estimates indicate that most of the bank capital buildup over the sample period can be explained by greater bank risk exposures and the market's increased demand that large banks' default risk be priced.

Sources of Bank Interest Rate Risk

We investigate bank stocks’sensitivity to changes in interest rates and the factors affecting this sensitivity. We focus on whether the exposure of commercial banks to interest rate risk is conditioned on certain balance sheet and income statement ratios. We find a significantly negative relation between bank stock returns and changes in interest rates over the period 1991–1996. We also find that bank characteristics measured from basic financial statement information explain bank stocks’sensitivity to interest rate changes. These results suggest that bank managers, analysts, and regulators can use this information to assess the relative risk exposure of banks.

The risk of foreign currency contingent claims at US commercial banks

This study investigates the relationship between market-based measures of risk and foreign currency contingent claims activity at US commercial banks. Specifically, four types of foreign currency contingent claims are examined: purchased foreign currency option contracts, foreign-exchange swaps, commitments to purchase foreign currency and forward contracts. Within the context of the Comptroller of the Currency's (OCC’s) Banking Circular 277, we differentiate between the risk exposure of dealer banks and non-dealer banks. Empirical results suggest that (i) the use of options tends to increase all market-based measures of bank risk, (ii) swaps are used primarily for risk-control purposes and (iii) the use of forward contracts and currency commitments contributes mildly, if at all, to any type of risk. There is some evidence that swaps activity at dealer banks increases unsystematic risk. Otherwise, dealer and non-dealer banks appear to similarly manage foreign currency risk.

Excess Risk Premia of Asian Banks

This paper develops a framework for gauging the risks of emerging market banks by using stock market data. Employing a multifactor asset pricing model that allows for time‐varying risk premia, we find the presence of large excess risk premia on Asian bank stocks, especially in those markets affected by the Asian financial crisis. We find that the excess risk premia appear to be negatively related to the degree of economic freedom of a country but positively related to its corruption level. Thus, our findings are consistent with the view that crony capitalism in Asia may have distorted the market mechanism or the systematic risk exposure of banks. This suggests that the excess risk premium provides useful information on risk exposure for opaque banking systems where quality accounting information is not available.

Financial Liberalization: Commercial Bank's Blessing or Curse?

The purpose of the paper is to evaluate and measure the effect of financial liberalization (FL) on bank risk exposure. We pursue these questions by assessing the changes in market-based asset values and risk exposure measures for commercial banks (CB) before and during a FL program. We do this for a sample of three countries: Malaysia, Taiwan and Thailand. We use a model based on the options pricing theory. We obtain estimates of the first and second moment of bank returns using an asset pricing model in which these two moments are a linear projection of a set of conditioning variables. This model was estimated using a GMM statistical procedure. Then we perform regressions explaining the evolution of bank risk measure around the FL event. The analysis and statistical test indicate that risk exposure of banks increases following a FL program, and this as a result of macroeconomic policy as well as changes in management controlled variables. This is so even for banks operating in countries that have undertaken very cautious FL processes such as Thailand and Malaysia. The results tend to support the proposition that moral hazard and bank risk taking may increase following FL. The results also suggest that banking crisis that often have followed FL may be more due to the behavior of banks' managers than previously reported in the FL literature.

Deposit insurance and bank interest rate risk: Pricing and regulatory implications

The linkage between the interest rate risk exposure of banks and the liabilities of a deposit insuring agency is not well understood. In this paper, a model is developed to evaluate the interest rate risk exposure of both deposit taking institutions and deposit insuring agents when bank equity has limited liability and interest rates are stochastic. Based on a sample of U.S. banks, empirical results are presented for the interest rate risk exposure of banks and its impact on the liabilities of the FDIC.

Loan commitments and bank risk exposure

Loan commitments increase a bank's risk by obligating it to issue future loans under terms it might otherwise refuse. However, moral hazard and adverse selection problems may result in these contracts being rationed or sorted. Depending on the relative risks of the borrowers who do and do not receive commitments, commitment loans could be safer or riskier on average than other loans. The empirical results indicate that commitment loans tend to have slightly better than average performance, suggesting that either commitments generate little risk or that this risk is offset by the selection of safer borrowers to receive commitments.

Disclosure policy and international banking

We develop general principles to guide the compulsory public disclosure of information about the financial condition of banks and apply these principles to three issues of particular relevance in international banking: (1) the disclosure of the country risk exposure of individual banks, (2) the rationale for hidden reserves, and (3) the disclosure of information regarding the availability to individual banks of emergency liquidity assistance. Our analysis shows why disclosure standards vary from country to country and why disclosure standards in the U.S. go well beyond the requirements elsewhere.

Market Evidence on the Effective Maturity of Bank Assets and Liabilities

THE RECENT YEARS' increase in interest rate volatility has intensified concern over the exposure of commercial banks to interest rate or funding risk. Since the effect of interest rate changes on the equity value of a bank depends on the or duration of the bank's assets and liabilities, assessing an individual bank's interest rate risk exposure requires information about the composition of its portfolio. It is difficult, however, to assess a bank's risk exposure from balance sheet data because several important asset and liability items have theoretically ambiguous maturities. In a frictionless market, a security's will equal its stated (or time to repricing). With market imperfections (e.g., depositors' transaction or information costs), however, the equilibrium cost of some deposit items may respond sluggishly or incompletely to market rate changes (see Hester and Pierce 1975 or Flannery 1982). Such liabilities' market values (discounted at market rates) would therefore fluctuate with the level of interest rates. These liabilities are sometimes called core deposits, which manifest sticky responses to market rate changes. We define an asset or liability's effective maturity as the of a fixed rate, perfectly elastically supplied security with the same market-value elasticity as the bank balance sheet item under consideration. Naturally, a balance sheet item's is the relevant determinant of its contribution to the bank's overall interest rate risk sensitivity.

Identifying "Problem" Banks: How Do the Banking Authorities Measure A Bank's Risk Exposure?

Identifying "Problem" Banks: How Do the Banking Authorities Measure A Bank's Risk Exposure?