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NEW RISK MEASURES FOR POST GLOBAL FINANCIAL CRISIS 2008 ERA
- Prof. Rajendra Shah
The Real Reasons for the Global Financial Crisis 2008
A common explanation that has been put forth about the real cause of the ongoing Global Financial Crisis that started in 2008 is the subprime mortgage lending. When significant number of those borrowers failed to meet their commitments, the lenders tried a recovery through selling of these mortgaged properties leading to a slump in the property market and subsequently assuring future recoveries to log losses and so on. The problem would have had a limited impact but for bold and beautiful tool of securitization . Use of securitization had multiplied the money available to lend many-fold and that was the reason why liberal subprime lending had become possible. The extensive use of securitization allowed the lenders to make hay because of untested optimism and lack of appropriate disclosure requirements. Some believe that unprecedented upward move of several months in oil price up to US $147.50 per barrel led to use of substitutes like ethanol as fuel and that fueled rise in food prices and inflation causing subprime borrowers to fail in their commitments. Whether introduction of uncontrolled securitization provisions and a calculated strategy to allow oil prices to soar had terror-studded political motives or not, three root causes of all that we witnessed are greed, Greed and GREED.
Credit Related Models
The failure of mortgage borrowers makes us examine various models around Credit for their robustness and accuracy. Credit Scoring Models: Credit score is a measure that can objectively assess credit risk of consumers. The objective of a credit scoring model is to maximize profits from lending operations. Credit scoring models can be built based on the experience data provided by banks about their past consumers. Credit bureau data can be helpful in testing and improving the accuracy of the credit scoring model. Credit scoring primarily determines the likelihood of default by a consumer based on the parameter values supplied by consumers in their credit application. It thus helps a bank to
Modern credit derivative pricing models rely on the probabilities estimated by credit migration models to generate fair pricing. The credit portfolio models have empowered banks to take advantage of the increasing liquidity of the credit markets and to adopt a far more active 5 4 3 2 . While the credit ratings indicate a company’s financial strength. If a company’s financial position strengthens. Bayesian method can be used to improve credit scoring models . developing credit migration models that are as accurate as possible is an essential task of risk management in front of us. profile of exposure keeps changing and the banks lending short-term loans should well understand their credit profiles in order to deploy capital efficiently and with optimum safety. Credit Portfolio Models: Following heavy losses in late eighties and early nineties. they do not talk about the chances of shifting or migrating into another rating. Credit portfolio models were developed to differentiate credit-risk along multiple dimensions and for large corporate exposures on an individual basis. the credit exposure models in addition to the first-payment default model are useful to deal with subprime borrowers. This is not conducive for building a scoring model. the banks started to develop more sophisticated credit risk management techniques that stressed on the credit risk of individual exposures and the intensities to which these risks were diversified. Credit migration modeling helps in this regard. Statistical methods have their limitations due to high correlation between factors. the risk to a lender is the borrower’s credit exposure. the purposes of loan. Credit Exposure Models: If a borrower defaults. the charge-off rates and the current market conditions are highly correlated. its credit rating goes down. 2 Credit Migration Models: The companies that have active bonds are evaluated continuously to determine their credit worthiness. The subprime borrower market is a uniquely homogeneous segment of the total borrower market. In case of sub-prime borrowers. This requires banks to identify the probabilities of first-payment defaults and in the event of a default.11th Global Conference of Actuaries make its credit granting decisions based on objective and consistent methods thereby limiting default incidents. The loan decision factors such as the risk of default. In such a situation. the absence of collateral. its credit rating goes up and if it weakens. Therefore. The banks would also like to minimize their obligation which can be done using a credit exposure model . The utility of credit migration models is evident from the fact that Basel-II agreement requires banks to use credit migration models that are subjected to less uncertainty to reduce unnecessary risk. the severity of obligation of the customer.
The bank’s cumulative distribution of sold (not marketed) loans is asymmetric. There are a number of credit portfolio models that are characterized by their correlation structures and choice of risk measures. etc. Building such models was an initial step towards more realistic models. Therefore models such as CAPM.11th Global Conference of Actuaries approach to credit portfolio management than was previously possible. APT which are developed under the assumption of normal distribution lead to misleading results. the risk of a portfolio was defined in terms of variance of return which required variances and covariances between the returns of all securities. 3 . Active credit portfolio optimization has enormous potential to enhance profitability. versatility. Limitations of Standard Risk Measures Most standard models are based on normal distribution.based and/or NPV. data availability. speed of calculation. The indicators of rising average exposure within the limit on a credit card. increasing frequency of delayed payment instances. Credit portfolio models are useful in • • • Solvency analysis Credit risk concentrations and portfolio optimization Sensitivity analysis and stress testing What Precautionary Indicators Could Have Helped in Avoiding the Crisis It appears that the sub-prime crisis could have been avoided had the lending institutions acted more cautiously in choosing their customers by paying adequate attention to their credit exposures.based. The advantages maybe in terms of simplicity. In real life situations. The disadvantages are also in terms of limitations imposed by the same features. The risk measures used by the models are loss. βs are almost abandoned in portfolio management techniques. The normal models are misfit in such cases. The concept of introduction of the β based portfolio method was motivated by insufficient data to compute the variance covariance matrix. In mean-variance model. Normal models cannot be applied to them. Now Boot-strapping techniques allow resolving this issue. we often come across investment returns where the distributions are leptokurtic and/or have heavy tails. As a result. increasing average delay times could have given early indications of the problems in the offing. leptokurtic and contains extreme values.
then f( ) is called coherent risk measure. They are not coherent and lead to non-convex risk measures and consequently to absurd results. Need to Design New Risk Measures The measures like Variance and VaR incase of non-elliptical joint distributions have two major drawbacks. Additionally. if the following properties hold.f(x) for λ > 0 and all random variables x Sub-additivity: f(x+y) ≤ f(x) + f(y) for all random variables x and y For risk measure f( ) satisfying the above properties. 2. viz. VaR is not a suitable risk measure for the following reasons: • • • • • • • It does not measure losses exceeding VaR It may provide inconsistent results at different confidence levels Non-convexity makes it impossible for the use of VaR in optimization problems A reduction of VaR may result in extending the tail beyond VaR Non-sub-additivity of the measure means that portfolio diversification may lead to an increase in the risk and does not allow to add up the VaR of different risk sources Many local extremes of VaR leads to unstable VaR ranking VaR can destabilize an economy and induce crashes that would not otherwise occur 6 Some desirable properties of a good risk measure are • • Positive homogeneity: f(λx) = λ. They fail to measure non-linear correlation between the random variables. convexity is implied.11th Global Conference of Actuaries To measure risk under very generic conditions the concept of VaR was introduced. the following coherent risk measures are developed • • • Expected Regret (ER) Conditional Value at Risk (CVaR) Expected Shortfall (ES) 4 . Basically VaRα is α-percentile of the loss distribution. To overcome the first drawback. 1. • • Monotonicity : x ≤ y implies f(x) ≤ f(y) for all random variables x and y Transitional invariance f(x+λr0) = f(x) – λ for all random variables x and real numbers λ and all risk free rates r0.
8 5 . Therefore copulas. Dependent extreme events have been the major sources of losses for banks. Economic capital in its simplest form. Newer Risk Measures and their Increasing Significance A variation of the VaR methodology known as economic capital is used to determine the expected funding and borrowing levels for credit and default funding and provisioning levels for credit and default expectations. Parametric models based on copulas such as Marshall-Olkin method and maximum likelihood method are useful but complex.” – Iman Van Lelyveld . measures of dependence based on copulas were developed. To overcome the second drawback listed above. economic capital models are becoming increasingly important. may be defined as sufficient surplus to cover potential losses at a given risk tolerance level over a specified time horizon. Non parametric dependence measures based on copulas still require some efforts to provide userfriendly algorithms. Economic capital is useful in • • • • • • • • • • Determining company/product risk profile Capital budgeting Evaluating required capital in merger/acquisition situations Insurance product pricing Assessing risk tolerance and constraints Asset Liability Management Calculating risk adjusted return on capital Performance measurement Incentive compensation Regulatory and rating agency discussions 7 “Playing a key role in both the second pillar of the new Basel framework and the Solvency II project.based measures need to be emphasized and strengthened. In case of continuous random variables. the definition of expected shortfall coincides with that of CVaR.11th Global Conference of Actuaries Expected Regret is defined as the expected value of the loss distribution beyond a threshold α CVaR is the expected value of the loss exceeding VaR.
10 9 Some New Measure Suggestions Credit Scoring models need to consider the following aspects to differentiate between customers: • • • • • • More open accounts that are reported as “Paid as agreed” More types of credit accounts More open accounts than closed accounts Low balance compared to credit limits More active accounts but with lower balances Fewer credit scoring assessment requests However. asset categories and hedge funds. Riskdata developed "ShockVaR" in around 2007 to overcome the possibility of overestimating risk during calm periods and underestimating it in highly volatile markets. care needs to be taken to ensure that customers’ credit rating does not go down if the credit card provider (increasingly possible under the current status of the global economy) • • slashes credit limit based on new norms closes unused or unprofitable accounts 6 . accurately pointed to the increased possibility of a dramatic drop in the Japanese equity markets in the week of October 2008 anticipating the big drop experienced on October 24. which focus on the maximum estimated amount of loss at a given time horizon for a specific confidence level. Riskdata’s ShockVaR calculations. may provide a better understanding of risk across markets. for example. economic capital may replace VaR in risk management in the time to come. Another new measure: “ShockVaR” developed by Riskdata .11th Global Conference of Actuaries The concept of economic capital is expected to gather momentum and according to James Lam . The goal of ShockVaR is to help investors better analyze their portfolios in the current market crisis. ShockVaR is expected to increase sharply within days of a shock or anticipated shock and drop down to its initial value if the market volatility is back to previous levels. ShockVaR is designed to be highly sensitive to market changes than typical VaR measures.
Use of option pricing model and neural networks for credit scoring can be useful. Active Credit Portfolio management by Andrew Kuritzes 6. By James Lam. I see rigorous researches and authentication through sensitivity analysis and scenario testing for various kinds of coherent risk measures and tools to be the order of 2009 and thereafter. Exploring the Limitations of Value at Risk: How Good Is It in Practice? By Andreas Krause. Posch and Christiane Schöne 3. pp 19-28 7. Published by John Wiley and Sons 10. Arner. Publisher: Capital Markets Law Journal.11th Global Conference of Actuaries The credit scoring models need to overcome vicious cycle effect. An improvisation of Economic capital using Bayesian approach may give a long handle. The Global Credit Crisis and Securitization in East Asia by Douglas W. What Is “Economic Capital?” . Paul Lejot and Lotte Schou-Zibell. Potential Exposure – How To Get A Handle On Your Credit Risk – By Jim Rich and Curtis Tange 5. REFERENCES 1. Winter 2003. ******** 7 .riskdata. http://www. 3: 291-319 2. Peter N. Economic Capital Modelling : Concepts. Journal of Risk Finance.com. By Eric Banfield 8. Bayesian Methods for Improving Credit Scoring Models by Gunter Löffler.2008. cascading effect of the use of credit scores and inaccuracy problems. Edited By Iman van Lelyveld 9. Enterprise Risk Management From Incentives to Controls. An Introduction to Credit Migration Modeling by Neil McBride 4. Measurement and Implementation.A Quick Guide to the Differences between Economic Capital and Regulatory Capital. Riskdata now providing free access to daily shockVaR and long term VaR indicators for major equity indices.
Operations Research. Business Mathematics. Business Statistics. He has vast experience of teaching a variety of actuarial subjects.11th Global Conference of Actuaries The author: Professor Rajendra Shah is the Managing Director of DS ActEd (DS Actuarial Education Services). Economics. Besides. Prof. and Computer Programming. Shah has authored eighteen text-books in the subjects of Statistics. Mathematics. 8 .
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