Deterioration In Credit Quality Research Articles

Default risk transmission in the travel and leisure industry

Default risk in the Travel and Leisure (T&L) industry remains understudied despite its implications for the industry’s health and stability. This paper investigates the transmission of default risk among US T&L firms over various credit horizons from July 22, 2008 to December 9, 2022, paying special attention to the impact of COVID-19. The short-, medium-, and long-term default risk factors are extracted from the Credit Default Spread (CDS) curve of the US T&L industry then used within a connectedness approach. The results reveal considerable default risk transmission, particularly in the long-term. Default risk transmission has spiked across all horizons since the pandemic, reflecting the deterioration in credit quality of T&L firms under the pandemic. Analysis of the drivers of default risk transmission shows that several macro-financial variables, especially news market sentiment and stock market volatility induced by the pandemic, have an important explanatory role.

The new challenges of global banking and finance

The economic downturn caused by the Covid-19 pandemic has brought unprecedented uncertainty to the global banking system. Banks are facing critical market challenges driven by uncertain monetary policies, deterioration in credit quality, and regulation and compliance pressures. These challenges highlight the importance of better understanding the new role of financial intermediations in facilitating efficient capital allocations and economic development. This article reviews the related literature on monetary policy uncertainty, bank performance, digital finance, and introduces articles on these themes. Finally, we propose potential areas for future research.

Assessing the impact of economic and financial shocks on SME credit quality: a scenario analysis

We estimate the impact of the Covid-19 pandemic on credit risk changes on a large sample of SME firms. The Altman Z”-Score model, which has proven to be a powerful and robust bankruptcy prediction model across many industries and countries, is used to assess over 1,000 SMEs from seven Polish industrial sectors. Specifically, we assess the vulnerability of the sampled firms to credit downgrades, including the likelihood of becoming insolvent and filing for bankruptcy, over the expected downturn in the real economy. Based on scenario analysis on individual firm financial data, we analyse rating transitions under multiple potential scenarios, focusing on the deterioration of the SME firms’ profits, and working capital including an increase in current liabilities. We find that the impact on companies from the various rating equivalent groupings are quite diverse and cannot be explained only by the firms’ industrial sector. Of particular importance is the proportion of firms whose credit quality deterioration could result in insolvency. What is perhaps surprising is that the most resilient companies with respect to credit downturns are, apart from the AAA/AA+ and AA/AA-rated, those which initially were assigned to the most risky (CCC) credit rating equivalent class. And, those that were assigned to lower investment grade classes were amongst the least resilient.

Heterogeneity in the Relationship Between NPLs and Real Economy: Evidence from the Mongolian Banking System

Abstract The paper analyses the relationship between the banks’ credit risk and macroeconomic conditions by addressing the following questions; (i) How are macroeconomic shocks transmitted to lending risk depending on the ban-specific features? (ii) Are the effects of macroeconomic shocks different across the loan portfolios in various economic sectors? Unlike the common assumption in the literature, the empirical analysis considers banks’ heterogeneity and diversification across borrowers. It employs heterogeneous panel SVARs and standard SVAR models on a dataset from 2002. Q1 to 2019.Q1. The results suggest that the deterioration in credit quality is affected by both macroeconomic and bank-specific factors, with substantial heterogeneity in the magnitudes and timing in terms of the type of loans in various business sectors and bank characteristics. In particular, we find strong evidence of cyclical sensitivity of loan quality, and about 1/4 of banks’ NPLs increases stronger in response to the shocks to growth, exchange rate, interest rate, and profitability. The highly profitable banks tend to less engage in excessive risk-taking, resulting in lower NPLs, whereas the relation of asset size to NPLs is not significant for the sample. A growth shock plays a prominent role in explaining the variation of NPLs for the trade and mining sectors. Similarly, the loan supply shock is the main determinant for the construction sector’s NPLs, while the exchange rate shock is the most responsible for the manufacturing sector. The interest rate shock and exchange rate shock are the most effective factors on NPLs of consumer loans. Finally, the feedback effect of NPLs shows that deterioration of credit quality slows down economic growth.

CONIC CVA AND DVA FOR OPTION PORTFOLIOS

In this paper, we propose a framework for credit and debit valuation adjustments (CVA and DVA, respectively) for options and option portfolios which is based on conic finance, that is, where the positions are valued at their bid or ask prices depending on whether they are assets or liabilities. This can be achieved by transforming the pricing measure via appropriate distortion functions, depending on (at least) one parameter. We apply our methodology, which is based on the Wang transform, to portfolios of European commodity futures options, and we show that both CVA and DVA are significantly impacted by bid-ask spreads, when compared to their traditional risk-neutral counterparts. In particular, we show that DVA decreases when computed under conic finance settings, which is in line with the regulatory efforts to rein in DVA gains for financial institutions resulting from their own credit quality deterioration. Finally, we investigate the robustness of our approach with respect to the calibrated parameters, and we show that the calibrated distortion parameter is an excellent explanatory variable for the observed bid-ask spreads.

Methods of Calculation of Expected Credit Losses Under Requirements of IFRS 9

The most important area of work for financial market regulators including International Accounting Standards Board is to clarify the metrics of credit assessment. This problem became particularly relevant after the financial crisis of 2008, when the insolvency of approaches to the assessment of credit risks adopted under the then international financial reporting standard IFRS (IAS) 39 became apparent, since credit losses on financial instruments were taken into account by the “loss model”, and therefore, the asset was recognized as financially impaired due to the fact of credit quality deterioration and significant time lag. From 1 January 2018 of a new international financial reporting standard IFRS9 IFRS 9 is based on a different approach — the principle of “expected credit losses” (ECL). The transition to IFRS 9 is intended to strengthen the banking system by increasing reserves , the banking system’s stability can be increased also. The new business model radically changes the approach to the formation of reserves, including by taking into account the impact of macroeconomic indicators on their value. According to various estimates, the scale of increase in reserves ranges from 30% to 50%. The purpose of this article is to systematize the methodological principles and approaches that underlie the requirements of IFRS 9 (basic and simplified and POCI approaches), as well as a comparison of the main methods for assessing the probability of default and expected credit losses (Weibul distribution, migration matrix, generator matrix ) In the framework of this article, the authors formulated criteria for the transfer of assets between the stages of credit risk (stage), and also formulated the principles for calculating expected credit risks for each stage, taking into account macroeconomic factors. This article is of practical value, as it can be the basis for the development of methods for calculating the expected credit risks of corporate clients of commercial banks, and can also be used to improve credit risk management models.

Oil and macro-financial linkages: Evidence from the GCC countries

We assess potential roles of recent oil price swings in macro – financial linkages for the case of the Gulf Cooperation Council (GCC) countries using bank-level panel data from 2000 – 2016. Employing both dynamic panel and panel VAR modelling, we document evidence indicating significant implications of oil price changes on the GCC financial and real sectors and significant macro – financial linkages. The results are robust in suggesting favourable effects of positive oil price changes on bank profitability, credit growth and output growth. Likewise, we document robust evidence indicating immediate contraction in credit growth, deterioration in credit quality and decline in economic growth following negative oil price changes. We also note that the implications of oil price changes tend to be felt more strongly by small banks. Finally, we find substantial causal interactions between output growth and bank variables, notable of which are robust findings of significant responses of (i) credit growth and bank profitability to business cycle and (ii) business cycle to credit quality. With the documented roles of oil prices on macro-financial linkages, the oil market developments should be monitored closely and, in anticipation of oil price drops, attention should be given to maintaining lending activity as well as safeguarding banks’ financial soundness such that the contraction of real activity can be contained.

Claim Dilution in the Municipal Debt Market

Using confidential loan-level data, we investigate the importance of bank loans in the debt structure of U.S. state and local governments. We show that most bank debt is closely substitutable with municipal bonds and that smaller, lower-income and less credit-worthy borrowers are more reliant on bank borrowing. Moreover, we document a sizable difference in the maturity structure of bonds and loans that allows municipalities to save on interest costs but that could also lead to diluting bondholders' claims. Such dilution concerns are amplified by governments substantially increasing bank borrowing in response to credit quality deterioration. This suggests the upward trend in bank borrowing will likely persist if fiscal positions continue to decline.

An Unexpected Crisis? Looking at Pricing Effectiveness of Heterogeneous Banks

Credit quality of loans to Italian firms dramatically worsened during the cyclical downturn of 2008–09, compared with the previous period of growth (2006–07). This paper shows that, if credit quality transition matrices (i.e. the change in the actual firms’ riskiness, gauged ex post) are mapped to interest rates (i.e. the conditions applied ex ante to the credit), banks appear to have been able at calibrating required risk premiums to actual firms’ idiosyncratic risk, both during expansion and recession. However, the uncertainty generated by the crisis emphasized the unexpected component of credit worsening, thus making evident flaws in pricing effectiveness. Moreover, banks’ organizational features did matter in driving the pricing effectiveness: the main finding is that larger banking groups were more affected than smaller ones by the sudden deterioration of credit quality, which was poorly reflected in their risk pricing on the eve of the crisis. The bank‐size effect can be tackled through an efficient use of hard or soft information: both the banks using quantitative credit rating models and highly decentralized banks showed an above‐average ability in calibrating rates to upcoming risk, suggesting that a clear‐cut adoption of a consistent lending technique outperforms more ambiguous strategies; banks with a strong relationship with borrowers smoothed the risk–price curve in normal times.

Rational Inattention and Counter-Cyclical Lending Standards

We develop a model of capacity-constrained lenders, who trade off the depth of their loan review with the number of funding applications they process. We find that better economic conditions cause the marginal return to scrutiny to decrease. Lenders therefore process more applications, but approve riskier loans that – paradoxically – generate lower expected returns. Our model rationalises the endogenous deterioration of credit quality during market booms, tighter lending standards during recessions, and counter-cyclical loan underwriting times.

Conic CVA and DVA for Option Portfolios

In this paper, we propose a framework for credit and debit valuation adjustments (CVA and DVA, respectively) for options and option portfolios which is based on conic finance, that is, where the positions are valued at their bid or ask prices depending on whether they are assets or liabilities. This can be achieved by transforming the pricing measure via appropriate distortion functions, depending on (at least) one parameter. We apply our methodology, which is based on the Wang transform, to portfolios of European commodity futures options, and we show that both CVA and DVA are significantly impacted by bid-ask spreads, when compared to their traditional risk-neutral counterparts. In particular, we show that DVA decreases when computed under conic finance settings, which is in line with the regulatory efforts to rein in DVA gains for financial institutions resulting from their own credit quality deterioration. Finally, we investigate the robustness of our approach with respect to the calibrated parameters, and we show that the calibrated distortion parameter is an excellent explanatory variable for the observed bid-ask spreads.

Liquidity Risk and Correlation Risk: A Clinical Study of the General Motors and Ford Downgrade of May 2005

The deterioration in credit quality of General Motors (GM) and Ford to junk status in the spring of 2005 caused a wide-spread sell-off in their corporate bonds. Using a novel dataset, we document that this sell-off appears to have generated significant liquidity risk for market-makers, as evidenced by a significant imbalance in their quotes towards sales. We find that simultaneously there was a substantial increase in the co-movement between innovations in the credit default swap (CDS) spreads of GM and Ford and those of firms in all other industries, the increase being the greatest during the period surrounding the actual downgrade and reversing sharply thereafter. We show that the corporate bond market makers' imbalance towards sales in GM and Ford bonds explains a significant portion of this co-movement. These results linking liquidity risk and correlation risk are consistent with models in which market prices are episodically determined by the limited risk-bearing capacity of financial intermediaries.

The Monitoring Incentive of Transactional and Relationship Lenders: Evidence from the Syndicated Loan Market

We identify a group of lenders specializing in syndicating tradable loans (referred to as transactional lenders [TLs]). We show that borrowers borrowing from TLs experience worse operating performance and more severe credit quality deterioration after loan origination compared to those borrowing from relationship lenders. This difference in the postloan issue performance remains robust after controlling for the potential self‐selection of the lender type, or using percentage of traded loans out of all syndicated loans to capture lenders’ propensity for syndicating tradable loans. Our results also remains qualitatively the same after we drop various types of risky loans.

The Role of Leverage in Firm Solvency: Evidence From Bank Loans

The two recessions that hit Italy since the end of 2008 have raised substantially the share of non-performing loans to businesses in banks’ portfolios. In this paper we evaluate to what extent the deterioration of credit quality resulted not only from the drop in firms’ sales during the contraction of economic activity, but also from the level of firms financial debt at the onset of the first recession. Our results show that, ceteris paribus, a 10 % points increase in leverage is associated with almost a 1 % point higher probability of default. Moreover, the adverse impact of a drop in sales on firm solvency is almost four times larger for firms in the highest quartile of the leverage distribution than for firms in the first quartile. These findings confirm that the firms’ financial structure can be a powerful amplifier of macroeconomic shocks. A higher level of borrowers’ leverage reduces their resilience during a recession, and this in turn weakens the balance-sheets of banks and their ability to provide credit.

The Role of Leverage in Firm Solvency: Evidence from Bank Loans

The two recessions that have hit Italy since the end of 2008 have raised the share of non-performing loans to businesses in banks’ portfolios substantially. In this paper we evaluate to what extent the deterioration of credit quality was due not only to the decline in firms’ sales during the contraction of economic activity, but also to the level of firms’ financial debt at the onset of the first recession. Our results show that, other things being equal, a ten percentage point increase in leverage is associated with a higher probability of default of almost one percentage point. Moreover, the adverse impact of a fall in sales on a firm’s solvency is almost four times greater for firms in the highest quartile of the leverage distribution than for firms in the first quartile. These findings confirm that firms’ financial structure can be a powerful amplifier of macroeconomic shocks. A higher level of leverage reduces firms’ resilience during a recession, and this in turn weakens the balance-sheets of banks and thus their ability to provide credit.

A primer on counterparty valuation adjustments in South Africa

Counterparty valuation adjustment (CVA) risk accounts for losses due to the deterioration in credit quality of derivative counterparties with large credit spreads. Of the losses attributed to counterparty credit risk incurred during the financial crisis of 2008-9 were due to CVA risk; the remaining third were due to actual defaults. Regulatory authorities have acknowledged and included this risk in the new Basel III rules. The capital implications of CVA risk in the South African milieu are explored, as well as the sensitivity of CVA risk components to market variables. Proposed methodologies for calculating changes in CVA are found to be unstable and unreliable at high average spread levels.

¿Reflejan los cambios de rating de la deuda variaciones en el riesgo de los emisores?

This study analyzes the effects of six different credit rating announcements on systematic and idiosyncratic risk in Spanish stocks from 1988 to 2010. We analyze announcement by the main rating agencies: Moody's, Standard & Poor's and Fitch. We apply an extension of the event study in a CAPM model. We find effects in both kinds of risk, indicating that rating agencies provide new information to the market. Rating actions that imply an improvement in credit quality cause lower systematic and idiosyncratic risk, with lower effect in beta risk. Conversely, ratings announcements that imply credit quality deterioration cause a rebalance in both types of risk, with higher beta risk being joined with lower diversifiable risk. Moreover, the risk responses depend on the characteristics of the announcement, the issuer and the economic environment.

How likely is contagion in financial networks?

Interconnections among financial institutions create potential channels for contagion and amplification of shocks to the financial system. We estimate the extent to which interconnections increase expected losses and defaults under a wide range of shock distributions. In contrast to most work on financial networks, we assume only minimal information about network structure and rely instead on information about the individual institutions that are the nodes of the network. The key node-level quantities are asset size, leverage, and a financial connectivity measure given by the fraction of a financial institution’s liabilities held by other financial institutions. We combine these measures to derive explicit bounds on the potential magnitude of network effects on contagion and loss amplification. Spillover effects are most significant when node sizes are heterogeneous and the originating node is highly leveraged and has high financial connectivity. Our results also highlight the importance of mechanisms that go beyond simple spillover effects to magnify shocks; these include bankruptcy costs, and mark-to-market losses resulting from credit quality deterioration or a loss of confidence. We illustrate the results with data on the European banking system.

Feedback effects of credit ratings

Rating agencies are often criticized for being biased in favor of borrowers, for being too slow to downgrade following credit quality deterioration, and for being oligopolists. Based on a model that takes into account the feedback effects of credit ratings, I show that: (i) rating agencies should focus not only on the accuracy of their ratings but also on the effects of their ratings on the probability of survival of the borrower; (ii) even when rating agencies pursue an accurate rating policy, multi-notch downgrades or immediate default may occur in response to small shocks to fundamentals; (iii) increased competition between rating agencies can lead to rating downgrades, increasing default frequency and reducing welfare.

The Monitoring Incentive of Transactional and Relationship Lenders: Evidence from the Syndicated Loan Market

We identify a group of lenders specializing in syndicating tradable loans (referred to as transactional lenders, “TLs”). We show that borrowers borrowing from TLs experience worse operating performance and more severe credit quality deterioration after loan origination compared to those borrowing from relationship lenders (“RLs”). This difference in the post-loan issue performance holds robust after controlling for the potential self-selection of the lender type, or using percentage of traded loans out of all syndicated loans to capture lenders’ propensity for syndicating tradable loans. Our results also remains qualitative the same after we drop various types of risky loans.