Top PDF International Banking and the Allocation of Risk

International Banking and the Allocation of Risk

International Banking and the Allocation of Risk

Nier, E., and U. Baumann (2003). Market Discipline, Disclosure and Moral Hazard in Banking, in: Corporate Governance: Implications for Financial Services Firms, proceedings of the 39th Annual Conference on Bank Structure and Competition, Federal Reserve Bank of Chicago, 261-277.

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Risk based capital allocation

Risk based capital allocation

Capital allocation means the process of distributing the capital to different business lines or portfolio elements. As financial markets are getting more and more rigorously regu- lated the importance of capital allocation is also increasing. In the article we are going to analyze six possible allocation methods and try to find out if there is any of them that both results allocation satisfying some reasonable requirements and both easy to em- ploy – so it can be advised for practical purposes. As both Hungarian and international studies are showing the capital allocation is not yet a very common practice at financial institutions, finding such a method might be a real benefit. We will show that if we use Expected Shortfall as risk measure Euler method is satisfying the above mentioned cri- teria: it fulfills the requirements of full allocation, core compatibility, riskless allocation and it is suitable for performance measurement. Furthermore it is really easy to calculate independently from the number of considered business lines.
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Risk Measures and Capital Allocation

Risk Measures and Capital Allocation

The capital allocation problem is that once the total risk capital for a multi-unit financial insti- tution (or a combination of different portfolios) is computed based on a specific risk measure, the risk capital must be allocated back to each business unit (or portfolio) in a consistent way which should recognize the benefit of diversification. Different allocation methods are avail- able; however, only some of them satisfy the nice properties which have economical meanings, while others do not. Those desirable properties were proposed as axioms of coherent alloca- tion (Denault, 2001) and fair allocation (Kim, 2007) (adapted from Valdez and Chernih (2003) which extended Wang’s 4 idea to the elliptical distribution class for capital allocation problem), respectively. They will be discussed in the next section.
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On the Impossibility of Fair Risk Allocation

On the Impossibility of Fair Risk Allocation

Kalkbrener (2005) shows that Linear Aggregation, Diversification and Continuity characterizes the gradient principle (or Euler method, where risk is allocated as a result of slightly increasing the weight of all the divisions) to be the only allocation which satisfies those requirements. Although those requirements are also natural, they are not related to the marginalistic re- quirements of Equal Treatment Property and Strong Monotonicity. In fact Kalkbrener (2005) explicitly assumes that the risk allocated to a division does not depend on the decomposition of the other divisions, only on the main unit. There is a related impossibility result by Buch and Dorfleitner (2008). They show that if one uses the gradient principle to allocate risk and Equal Treatment Property is satisfied, then the measure of risk must be linear, not allowing for any diversification benefits.
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On the impossibility of fair risk allocation

On the impossibility of fair risk allocation

In a risk allocation game, an allocation rule shows how to share the diver- sification benefits of the main unit among the divisions, which has of course consequences on the performance evaluation or on the amount of capital allocated. In this paper besides having a none-empty core, (1) Core Com- patibility, we consider three other reasonable properties which a “fair” risk allocation rule should meet. Young (1985) has characterized the Shapley value on the class of all games as the only method satisfying (2) Pareto Op- timality (also called Efficiency), (3) Equal Treatment Property (also called Symmetry) and (4) Strong Monotonicity. In our opinion, these axioms are very natural requirements for a “fair” allocation rule. We interpret them as follows.
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Risk Based Capital Allocation

Risk Based Capital Allocation

As opposed to e.g. equity capital, regulatory capital or capital invested, the conception of risk based capital or risk adjusted capital 1 RAC is usually understood to be a purely internal capi- tal conception. Culp [3, p. 16] defines risk based capital as the smallest amount of capital a company must set aside to prevent the net asset value or earnings of a business unit from fal- ling below some “catastrophic loss” level. Because this capital is never actually invested, RAC is an imputed buffer against unexpected and intolerable losses. As well the allocation of risk based capital is usually understood as a notional or pro forma allocation of capital. 2
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Money market derivatives and the allocation of liquidity risk in the banking sector

Money market derivatives and the allocation of liquidity risk in the banking sector

reasoning why the interbank spot money market is unable to provide an efficient liquidity insurance to individual banks. The reason put forward in these papers is that banks are hit by idiosyncratic liquidity shocks that are not publicly observable. Given this informa- tional asymmetry, the interbank spot market is not an incentive-compatible mechanism that can implement the optimal risk-sharing among banks. In contrast, as Allen and Gale (2000) and Freixas, Parigi, and Rochet (2000) show, interbank lines of credit or interbank deposit contracts can implement an efficient risk sharing among banks in such a setting. These interbank contracts provide a self-revealing mechanism that implements the optimal insurance against idiosyncratic liquidity shocks. Thus this literature also shows that interbank credit lines or interbank deposits improve the liquidity allocation in the banking system as compared to the interbank spot market. However, the reason is complementary to our line of argument. While in this strand of the literature, interbank credit lines offer an incentive compatible mechanism to reveal private information about individual liquidity shocks, our argument shows that credit lines offer a commitment de- vice to refrain from exploiting informational advantages on systemic liquidity shocks and credibly commit to disseminate this information to other banks. Thus our paper develops an argument explaining why banks, in addition to trading in the interbank spot market, use money market derivatives.
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Essays on international portfolio allocation
and risk sharing

Essays on international portfolio allocation and risk sharing

We know from a vast literature following Bansal and Yaron (2004) that recursive preferences can account for many asset market facts when combined with ‘long-run risks’, which refer to the slow-moving long-run predictable component in consump- tion growth rates. Colacito and Croce (2010) applies the closed economy framework of Bansal and Yaron (2004) to a two-country two-good endowment economy with complete markets where endowments in each country follow a unit root process and have a small predictable component that is stochastic and highly correlated across countries. In their model, a positive shock to the predictable component of the growth rate of home endowment implies a big improvement in home utility due to recursive preferences. Efficient risk sharing requires that resources are transferred from home to foreign. As a result, home consumption falls while real exchange rate depreciates, which helps the model account for the consumption-real exchange rate anomaly. These findings suggest that specifying permanent shocks with a predictable component might be key for time-non-separability to matter for portfolio allocation and international risk sharing as it would imply larger fluctuations in intertempo- ral uncertainty factors, g t+1 and g t+1 ∗ . Chapter 1 discusses the role of news shocks
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Risk capital allocation and risk quantification in insurance companies

Risk capital allocation and risk quantification in insurance companies

up to the total portfolio risk) can be calculated. Theoretical and practical aspects of different allocation methods have been analyzed in a number of papers, for in- stance, Merton and Perold (1993); Tasche (1999); Overbeck (2000); Myers and Read (2001); Denault (2001); Fischer (2003); Urban et al. (2004); Buch and Dorfleitner (2008); Dhaene et al. (2010). The allocation method according to Merton and Per- old (1993) is based on option pricing theory. This approach is an incremental risk capital allocation which focus on what happens to the insolvency put option if each lines of business are added or removed from the firm. Tasche (1999) shows that the only method that is suitable for performance measurement is the Euler’s method. He also defines per unit contributions of quantile risk measures. Overbeck (2000) studies the variance-covariance allocation method. Denault (2001) provides the Shapley and the Aumann-Shapley methods which are based on game theory. He adds that under proper conditions the Aumann-Shapley method coincides with the Euler’s method. Myers and Read (2001) show how option pricing methods can be used in risk capital allocation. Fischer (2003) studies the Euler’s method where the chosen risk measure is a downside risk measure. Albrecht (2004) provides a review of allocation methods. Urban et al. (2004) compares different allocation methods in a scenario of a non-life insurance portfolio. Buch and Dorfleitner (2008) are concerned with the axioms of coherent risk measures and coherent allocation principles. They show the equivalence of some axioms under proper conditions. Buch et al. (2009) consider the optimization problem of a firm (multi-line) under RORAC framework. Dhaene et al. (2010) provide different allocations methods considering an optimisation argument, that requires the weighted sum of measures for the deviations of the business lines losses from their respective allocated capitals be minimised.
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Portfolio Allocation and International Risk Sharing

Portfolio Allocation and International Risk Sharing

Our paper is closely related to the literature on country portfolios. Heathcote and Perri (2007), Kollmann (2006), Collard et al (2008), Engel and Matsumoto (2009) and Coeurdacier et al (2010) propose di¤erent models that can generate realistic portfolio positions under e¤ectively complete markets. There is also a range of papers that analyse equilibrium portfolios under incomplete markets. Coeurdacier et al (2007) specify an incomplete market model with supply, demand and redistributive shocks and trade in stocks and bonds to match the basic stylized facts on international portfolios. Hnatkovska (2010) analyses endogenous portfolio choice under incomplete markets in a model with tradable and non-tradable sectors and examines the dynamics of portfolio choice to reconcile the home bias in equity holdings with the high turnover and high volatility of interna- tional capital ‡ows. Using di¤erent modelling frameworks, Coeurdacier and Gourinchas (2009) and Benigno and Nisticó (2009) also study endogenous bond and equity portfolios under incomplete markets. However, they mainly focus on di¤erent hedging motives behind equilibrium portfolio positions, e.g. whether home equity bias is driven by non-diversi…able labour income risk or real exchange rate risk, rather than analysing the implications of portfolio allocation for international risk sharing and consumption-real exchange rate anomaly.
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Risk Measures and Capital Allocation Principles for Risk Management

Risk Measures and Capital Allocation Principles for Risk Management

Cai and Wei (2014) defined new notions of dependence structure for the optimal capital allocation problems. You and Li (2014) further studied the capital allo- cation concerning mutually interdependent random risks, and they proved that more capital should be allocated to the risk with a larger reversed hazard rate when risks are coupled by an Archimedean copula for risk-averse insurers with decreasing convex loss functions. In addition, they developed sufficient conditions to exclude the worst capital allocations for random risks with Archimedean copu- las. Inspired by the works of generalized quantiles in Bellini et al. (2014), we will investigate the optimization problem considering both the positive and negative parts of the potential loss for each business line.
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Risk based capital allocation

Risk based capital allocation

The second reason is a rise in competition barriers. Corruption affects competition in two ways. The first way is that the institutional fragility makes the transaction costs higher. In corruption free countries, the economic agents, because of low transaction costs, have the ability to change partners very often. Contrary to this, in corruption ridden economies, the rational agents should be incited to form partnerships, in order to protect themselves from high transaction costs. As a consequence, these partnerships are difficult to join for the outsiders, and difficult to quit for the insiders. This results in the fact that the membership in these partnerships is often rewarded in a cut in a certain monopoly, but paid by long- standing loyalty to the alliance, and a prime paid to every transaction committed with a partner. From the outsider point of view, the fact that it is difficult to join a partnership, leads to the fact that the outsider enterprises, especially the foreign ones, have high un- institutionalized entry barriers to the market. It should not be forgotten that even to form a partnership it takes year of investing in seeking a right partner, which also constitutes a considerable economic loss of resources, otherwise usable in productive activities. As for the third reason, it is not possible to keep the credit system, because the law and economic system is incapable of protecting a lender. In this kind of system, these are the borrowers who are protected, because they are not forced to return the resources they have borrowed, because the judicial system is unstable. This incites the creditors to raise the cost of the credit, which in turn raises the business risk, makes business ventures more expensive, raises the costs of investments, raises the general price level, and all in all, lessens the efficiency.
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INTERNATIONAL BANKING. best practices: Foreign exchange risk management

INTERNATIONAL BANKING. best practices: Foreign exchange risk management

Forecast risk involves future transactions where revenues will be denominated in one currency and expenses in another. The risk has to do with the ultimate accuracy of the forecasts for future currency exchange and how it affects future margins. This can cause the realized value of receipts to vary significantly from the amount that was budgeted. It can also lead to differences in period-over-period comparisons. This risk would arise, for example, when a U.S. manufacturer exports its products to germany and receives payment in euros (eUr) at some future date. between the time a sale is projected and the time at which the sale is made, profit margins will vary with changes in the eUr/USD exchange rate. hedge accounting treatment is essential in avoiding such earnings volatility. In the absence of cash flow hedge accounting, the hedge instrument would have to be revalued at each accounting period (affecting earnings) prior to the time the sale is recognized. Cash flow hedge accounting enables the earnings impact of the hedge instrument to be matched up with the exposure recognition in the income statement.
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International banking, risk, and U.S. regulatory policies

International banking, risk, and U.S. regulatory policies

As a possible way of dealing with this potential problem, the Federal Reserve is exploring a supervisory approach that would focus on the degree of country concentration of foreign loans[r]

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Benefits of International Banking in 2009

Benefits of International Banking in 2009

2.3 Interaction between bank- and market-based international intermediation It is widely recognised that bank-based and market-based activities perform complementary functions. Both are often inseparable aspects of financial intermediation that depend heavily on the resilience of market infrastructure. The same is true in the international dimension. For instance, banks invest retail deposits in foreign securities, lengthening the intermediation chain by involving markets. Or they issue debt in international markets to fund corporate loans and other assets. International banks’ reliance on market-based funding increased at the beginning of the crisis as many of them had to fund the assets of off-balance sheet vehicles that they had taken onto their balance sheets. Conversely, markets rely on banks to alleviate issues arising from limited public information about financial counterparties, especially when these issues stem from international transactions. In addition, banks provide liquidity by engaging in market-making activities, providing credit lines or custodial services. Financial frictions help underscore the functional differences between markets and banks and hence the circumstances under which each channel for intermediation may have a comparative advantage. Bank-based intermediation may offer risk-smoothing services – by maintaining, for example, a close link between prices and fundamentals – that financial markets cannot provide. Furthermore, long-term bank-client relationships may underpin the only source of credit when asymmetric information, moral hazard or financial frictions are particularly acute (Levine (1997), Allen and Gale (2000), Demirgüç-Kunt and Levine (2001), Arcalean et al (2007)). That said, bank-based intermediation could also be suboptimal if it is associated with excessive rent-seeking by banks, to the detriment of economic growth (Weinstein and Yafeh (1998)).
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Margins of International Banking: Is there a Productivity Pecking Order in Banking, too?

Margins of International Banking: Is there a Productivity Pecking Order in Banking, too?

Modern trade theory emphasizes firm-level productivity differentials to explain the cross- border activities of non-financial firms. This study tests whether a productivity pecking order also determines international banking activities. Using a novel dataset that contains all German banks’ international activities, we estimate the ordered probability of a presence abroad (extensive margin) and the volume of international assets (intensive margin). Methodologically, we enrich the conventional Heckman selection model to account for the self-selection of banks into different modes of foreign activities using an ordered probit. Four main findings emerge. First, similar to results for non-financial firms, a productivity pecking order drives bank internationalization. Second, only a few non-financial firms engage in international trade, but many banks hold international assets, and only a few large banks engage in foreign direct investment. Third, in addition to productivity, risk factors matter for international banking. Fourth, gravity-type variables have an important impact on international banking activities.
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Limits to international banking consolidation

Limits to international banking consolidation

Of course, our results only hold if the number of regions with different risk structures is not abundant. If this was the case then - by the law of large numbers - a complete merger of banks in all existing regions would help to diversify away all risks. Moreover, financial distress in single regions would not cause the breakdown of the entire system because the excess liquidity need in one region would be relatively low. However, if the number of regions is limited, the financial distress in one region may cause a breakdown of a bank that operates in the entire economy. This is what we shall assume in this paper. Similar to banks in Kashyap, Rajan, and Stein (2002) deposit institutes in our frame- work try to economize on their overall liquidity risk by combining negatively correlated liquidity risks across regions. Consequently, if it is very likely that two regions are hit by (offsetting) liquidity shocks a two-regional bank merger (or a bank operating in two regions, respectively) can reduce the overall liquidity risk of the financial institution. If it is on the other hand rather likely that a liquidity shock only occurs in one region at the same time, then the risk that such a regional shock might induce a collapse of the multinational banks is too high. Multinational banks are inefficient in this case–banks should operate only in one region. Financial risk that is concentrated on single regions makes it desirable to partition the economy completely.
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International Asset Allocation: A New Perspective

International Asset Allocation: A New Perspective

debated, modern asset pricing theories link this return predictability to hedging demands of investors. Different sensitivities of asset returns to the underlying state variables that generate time-varying market returns cause risk premiums on the assets to differ. Accordingly, the additional risk premiums that are attributable to currency risk hedging will contribute to this predictability 7 . More generally, mounting empirical evidence suggests that, in contrast with a long tradition of results, asset returns are (at least partially) predictable. Following the lead of De Bondt and Thaler (1985), Chen, Roll and Ross (1986) and Fama and French (1989), recent research 8 has provided strong evidence that stock returns are partially persistent 9 . Similarly, evidence reported by Fama and Bliss (1986) and more recently by Cochrane (1999) suggests that the expectations hypothesis for bond returns seems to perform poorly, at least at short (one year) horizons. On the same grounds, the predictability of international equity returns has been empirically tested by Harvey (1991), Bekaert and Hodrick (1992), Ferson and Harvey (1993), Lamont (1998) and Fama and French (1998). Ignoring this predictability may lead to important welfare losses. For example, the empirical work of Glen and Jorion (1993) strongly suggests that international portfolios hedged against currency risks outperform (in a mean-variance sense) equivalent non-hedged ones, the measure of performance being the Sharpe ratio. Also, two studies by Solnik (1993, 1998) on international equity portfolios indicate that, if in the very long run hedging currency risk is unimportant, in the short or medium term, there is room for optimal, investor specific, currency risk hedging. More generally, Balduzzi and Lynch (1999) have recently shown that the (utility) costs of behaving myopically and ignoring predictability can be substantial. Finally, all the risk premiums have consistently been shown to vary over time and consequently the length of the investor’s horizon is a crucial parameter, as argued by Barberis (2000). For instance, Brennan, Schwartz and Lagnado (1997) found that (longer horizon) portfolio strategies that take into account the predictability of asset returns significantly outperform (short horizon) portfolio strategies that ignore it.
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INTERNATIONAL BANKING AND FINANCE INSTITUTE

INTERNATIONAL BANKING AND FINANCE INSTITUTE

macroprudential framework in the European Union, tools to analyse credit developments and credit risk, foreign currency lending, and how macroprudential policy, microprudential supervision and monetary policy interact. Part of the course will be devoted to the functioning and calibration of specific macroprudential tools, such as the countercyclical capital buffer, limits on loan-to-value ratios, or surcharges for systemically important banks. The lectures will be complemented by workshops in which participants will use EViews and Excel to analyse various micro- and macroprudential policy issues. Participants are expected to deliver short presentations and engage in group discussions on key financial stability issues in their countries. The course will cover the following topics:
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Measuring the efficiency of capital allocation in commercial banking

Measuring the efficiency of capital allocation in commercial banking

In addition to influencing expected cash flows, the current production plan affects the bank’s required return on capital, k i . If we assume that a single-factor, asset-pricing model adequately describes the bank’s securities, the required return is a function of the bank’s market “beta” and, to the extent that its expected costs of financial distress are significant, it is also a function of the bank’s idiosyncratic risk. Since the bank produces these securities using the comparative advantage it obtains from demand deposits, it can alter the trade-off between the expected return and riskiness of its bank-specific assets through the resources and skill it brings to bear on the tasks of credit evaluation, contract writing, monitoring, and managing clients’ financial distress. A change in these factors can alter the bank’s exposure both to systematic risk, measured by “beta,” and to idiosyncratic risk, measured by the market model’s standard error. These factors are, of course, components of the bank’s current production plan. Consequently, they are endogenous to the production process.
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