Systemic Risk & Risk Management

COMMENTARY

Cliff Rossi Discusses the New Financial Risk Agency on CSPAN [VIDEO]
The recent financial crisis has highlighted that poor risk management practices can lead to considerable value destruction. Executives and board members have since become much more focused on improving risk management processes within their organizations. The Risk Management track of CFP will disseminate thought leadership on risk management issues, and will partner with practitioners and policy makers to hold roundtables and speaker series to share views on how to improve effective risk management practices.

WORKING AND WHITE PAPERS

Systemic Risk and Network Formation in the Interbank Market
By Ethan Cohen-Cole, Eleonora Patacchini, and Yves Zenou
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Abstract: We propose a novel mechanism to facilitate understanding of systemic risk in financial markets. The literature on systemic risk has focused on two mechanisms, common shocks and domino-like sequential default.

Our approach is a formal model that provides an intellectual combination of the two by looking at how shocks propagate through a network of interconnected banks. Transmission in our model is not based on default. Instead, we provide a simple microfoundation of banks’ profitability based on classic competition incentives. As competitors lending quantities change, both for closely connected ones and the whole market, banks adjust their own lending decisions as a result, generating a ‘transmission’ of shocks through the system. We provide a unique equilibrium characterization of a static model, and embed this model into a full dynamic model of network formation with n agents. Because we have an explicit characterization of equilibrium behavior, we have a tractable way to bring the model to the data. Indeed, our measures of systemic risk capture the propagation of shocks in a wide variety of contexts; that is, it can explain the pattern of behavior both in good times as well as in crisis

Anatomy of Risk Management Practices in the Mortgage Industry: Lessons for the Future
by Clifford V. Rossi
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Summary: Not since the Great Depression has there been a contraction in the U.S. housing market of such scale. With much attention given already to complex mortgage securities, their risks and impacts on financial markets, this study examines the underlying loan manufacturing process that greatly contributed to excessive risk building across portfolios and mortgage securities alike. Particular attention is focused on the dynamics behind risk taking within mortgage firms leading up to the collapse in housing in order to understand what drove these firms to the brink and what lessons can be learned.

A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk
by CFP Academic Fellow Viral V. Acharya with Itamar Drechsler and Philipp Schnabl
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Abstract: We show that financial sector bailouts and sovereign credit risk are intimately linked.

A bailout benefits the economy by ameliorating the under-investment problem of the financial sector. However, increasing taxation of the non-financial sector to fund the bailout may be inefficient since it weakens its incentive to invest, decreasing growth. Instead, the sovereign may choose to fund the bailout by diluting existing government bondholders, resulting in a deterioration of the sovereign's creditworthiness. This deterioration feeds back to the financial sector, reducing the value of its guarantees and existing bond holdings as well as increasing its sensitivity to future sovereign shocks. We provide empirical evidence for this two-way feedback between financial and sovereign credit risk using data on the credit default swaps (CDS) of the Eurozone countries and their banks for 2007-11. We show that the announcement of financial sector bailouts was associated with an immediate, unprecedented widening of sovereign CDS spreads and narrowing of bank CDS spreads; however, post-bailouts there emerged a significant co-movement between bank CDS and sovereign CDS, even after controlling for banks' equity performance, the latter being consistent with an effect of the quality of sovereign guarantees on bank credit risk.

Systemic Risk and Network Formation in the Interbank Market
By Ethan Cohen-Cole, Eleonora Patacchini, and Yves Zenou
Download Working Paper

Abstract: We propose a novel mechanism to facilitate understanding of systemic risk in financial markets. The literature on systemic risk has focused on two mechanisms, common shocks and domino-like sequential default.

Our approach is a formal model that provides an intellectual combination of the two by looking at how shocks propagate through a network of interconnected banks. Transmission in our model is not based on default. Instead, we provide a simple microfoundation of banks’ profitability based on classic competition incentives. As competitors lending quantities change, both for closely connected ones and the whole market, banks adjust their own lending decisions as a result, generating a ‘transmission’ of shocks through the system. We provide a unique equilibrium characterization of a static model, and embed this model into a full dynamic model of network formation with n agents. Because we have an explicit characterization of equilibrium behavior, we have a tractable way to bring the model to the data. Indeed, our measures of systemic risk capture the propagation of shocks in a wide variety of contexts; that is, it can explain the pattern of behavior both in good times as well as in crisis.

Corporate Risk Management: Integrating Liquidity, Hedging, and Operating Policies
by Andrea Gamba and Alexander J. Triantis
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Abstract: We present a dynamic structural model of integrated risk management that incorporates several motivations for managing risk.

Risk management is enabled through a coordination of operating flexibility, liquidity management, and derivatives hedging policies. We analyze the value created by such integrated risk management strategies, and disintegrate this value in several ways to separate out the marginal impacts of specific frictions and of different risk management solutions. We highlight the importance of distress costs as well as a convexity due to personal taxes on equity income. We show that liquidity serves a critical role in risk management, providing a rationalization for seemingly high levels of cash reserves. The value attributable to derivatives usage does not appear to be significant in the presence of other risk management mechanisms, though we identify circumstances where this value is larger, thus helping to resolve conflicting empirical evidence on this issue. We examine why a significant portion of the value loss due to frictions in the presence of uncertainty still remains even under the integrated risk management strategy we employ. Finally, we evaluate the net impact of risk management policies in the presence of financial agency problems that distort these policies.

Knowledge Representation and Information Management for Financial Risk Management: Report of a Workshop
By Mark D. Flood, Albert P. Kyle and Louiqa Raschid
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Abstract: The National Science Foundation and The Pew Charitable Trusts co-sponsored a Workshop on Knowledge Representation and Information Management for Financial Risk Management on July 21 and 22, 2010 in Arlington, Virginia (see Flood, Kyle and Raschid, 2010).

The goal of the workshop was to initiate a research discussion about the knowledge representation challenges for effective financial information management. Over fifty invited academic researchers, financial regulators and industry practitioners participated in the event. The participants brought diverse perspectives and expertise in economics, computer science, finance, and information science, resulting in an interdisciplinary exchange of ideas. The specific topics covered a broad range, including financial risk management, ontologies for knowledge representation, formal logics, schema mapping, systemic risk, constraint languages, networks, simulation techniques, data integrity, operational risk and data security, to name a few. This report describes the discussions flowing from the workshop and its immediate aftermath in greater detail. We hope, however, that this is only the beginning of a much longer conversation.

The Financial Sector and the Real Economy During the Financial Crisis: Evidence from the Commercial Paper Market
by Ethan Cohen-Cole, Judit Montoriol-Garriga, Gustavo Suarez, Jason Wu
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Abstract: Shocks to the financial sector led credit spreads to widen to unprecedented levels in many markets during the 2007-2008 financial crisis.

The rise in spreads attracted attention because it could signal a disruption in financial markets, which has been widely linked to an increased burden on non-financial firms. This paper disentangles the relative contributions of credit and liquidity risk in explaining the widening of commercial paper spreads. In doing so, we find that liquidity risk was isolated to the financial sector throughout the first two major shocks to the system (August 2007 and March 2008). Indeed, controlling for credit risk, non-financial corporations saw little or no change in the cost of funding during this time period. After the bankruptcy of Lehman Brothers, for the first time, liquidity problems in the commercial paper market spilled out of the financial sector into the spreads of low credit quality non-financial firms. This effect had a disproportionately larger impact on those low credit-quality non-financial firms that placed paper exclusively through financial sector dealers. High credit quality firms remained unaffected throughout. Our interpretation of the results is that markets were able to differentiate not only between safe and imperiled firms in the midst of the crisis, but also to isolate where liquidity effects were most likely to be salient.

Looking Behind the Aggregates: A Reply to “Facts and Myths about the Financial Crisis of 2008”
by Ethan Cohen-Cole, Burcu Duygan-Bump, Jose Fillat, Judit Montoriol-Garriga
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Abstract: As Chari et al (2008) point out in a recent paper, aggregate trends are very hard to interpret.

They examine four common claims about the impact of financial sector phenomena on the economy and conclude that all four claims are myths. We argue that to evaluate these popular claims, one needs to look at the underlying composition of financial aggregates. Our findings show that most of the commonly argued facts are indeed supported by disaggregated data.

Corporate Financial Distress and Bankruptcy: A Survey
By Lemma W. Senbet and Tracy Yue Wang
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PRESENTATIONS

Private Mortgage-Backed Securitization Under Dodd-Frank, GSE Reform and Beyond
presented by Clifford Rossi at an April 4th PRMIA webinar
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Summary: This webinar describes the current regulatory landscape affecting mortgage securitization including Dodd Frank provisions for risk retention and the Qualified Residential Mortgage (QRM) rule, as well as the recent Treasury and HUD proposal for reforming Fannie Mae and Freddie Mac. The discussion also focuses on challenges to reviving private label securitization, the federal government's near-term approach to reducing its involvement in mortgage secondary markets and what the various GSE options mean for policy and the future of the mortgage industry.

Risk Management Implications of the Dodd-Frank Act
presented by Viral Acharya and Clifford Rossi
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Summary: On a GARP-sponsored webcast on January 11, 2011, Clifford Rossi of the Center for Financial Policy and Viral Acharya of NYU Stern discussed how risk managers’ day-to-day priorities will likely be affected by the Dodd-Frank Act.

BOOKS

Handbook on Systemic Risk, edited by Jean-Pierre Fouque,University of California, Santa Barbara and Joseph A. Langsam, Policy Fellow, Center for Financial Policy