Managing and Measuring Risk Emerging Global Standards and Regulation After the Financial Crisis

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1 Managing and Measuring Risk Emerging Global Standards and Regulation After the Financial Crisis

2 World Scientific Series in Finance (ISSN: ) Series Editor: William T. Ziemba (University of British Columbia (Emeritus), ICMA Centre, University of Reading and Visiting Professor of University of Cyprus, Luiss Guido Carli University, Rome, Sabanci University, Istanbul and Korea Institute of Science and Technology) Advisory Editors: Greg Connor (National University of Ireland, Maynooth, Ireland) George Constantinides (University of Chicago, USA) Espen Eckbo (Dartmouth College, USA) Hans Foellmer (Humboldt University, Germany) Christian Gollier (Toulouse School of Economics, France) Thorsten Hens (University of Zurich) Robert Jarrow (Cornell University, USA) Hayne Leland (University of California, Berkeley, USA) Haim Levy (The Hebrew University of Jerusalem, Israel) John Mulvey (Princeton University, USA) Marti Subrahmanyam (New York University, USA) Published Vol. 1 Vol. 2 Vol. 3 Vol. 4 Bridging the GAAP: Recent Advances in Finance and Accounting edited by Itzhak Venezia & Zvi Wiener (The Hebrew University of Jerusalem, Israel) Calendar Anomalies and Arbitrage by William T. Ziemba (University of British Columbia, Canada & ICMA Centre, University of Reading, UK) Social Security s Investment Shortfall: $8 Trillion Plus and the Way Forward Plus How the US Goverment s Financial Deficit Reporting = 64 Madoffs by Nils H. Hakansson (University of California, Berkeley, USA) Stochastic Programming: Applications in Finance, Energy, Planning and Logistics edited by Horand Gassmann (Dalhousie University, Canada) & William T. Ziemba (University of British Columbia, Canada & ICMA Centre, University of Reading, UK) Vol. 5 Managing and Measuring Risk: Emerging Global Standards and Regulations after the Financial Crisis edited by Oliviero Roggi (University of Florence, Italy & New York University, USA) & Edward I. Altman (New York University, USA) Forthcoming Quantitative Methods in Risk Analysis: A Practitioner s Guide by Michael Foster & Leonard MacLean

3 World Scientific Series in FINANCE vol. 5 Managing and Measuring Risk Emerging Global Standards and Regulation After the Financial Crisis Editors Oliviero Roggi University of Florence, Italy & New York University, USA Edward Altman New York University, USA World Scientific NEW JERSEY LONDON SINGAPORE BEIJING SHANGHAI HONG KONG TAIPEI CHENNAI

4 Published by World Scientific Publishing Co. Pte. Ltd. 5 Toh Tuck Link, Singapore USA office: 27 Warren Street, Suite , Hackensack, NJ UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. World Scientific Series in Finance Vol. 5 MANAGING AND MEASURING RISK Emerging Global Standards and Regulations After the Financial Crisis Copyright 2013 by World Scientific Publishing Co. Pte. Ltd. All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher. For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to photocopy is not required from the publisher. ISBN In-house Editor: Sandhya Venkatesh Typeset by Stallion Press enquiries@stallionpress.com Printed in Singapore.

5 Foreword MEASURING AND MANAGING RISKS: KEYNOTE IDEAS FROM THE INTERNATIONAL RISK MANAGEMENT CONFERENCES The idea for an international conference on Risk Management (IRMC) was conceived and eventually organized at the time the great financial crisis of 2008 was forming and becoming ominous. The Editors had little ideas, however, the main themes of this conference would become as timely and critical as it did, and so quickly, although one of the Editors had predicted a meltdown in global credit markets in spring of 2007 for reasons that were overshadowed by the incredible debacle in residential mortgage market structured securities in the U.S., and elsewhere. Over the next five years, including the inaugural Risk Management Conference in Florence in June 2008, the main subjects addressed at our annual meetings were clearly related directly to the major concerns in the world of finance and sovereign economics. Our strategy for the IRMC Conferences was quite simple complement a fairly wide swatch of risk topics presented by global scholars, with an extremely high level of Academic Keynotes and Featured Speakers and a Practitioner Workshop. The latter had to be timely and provocative. We were extremely fortunate to have attracted distinguished keynote presentations and the parallel scholarly sessions consistently improved both in quality and quantity. The contents of this volume are a large majority of the Keynote/Feature presentations from our conferences in the form of research papers related to (A) The Evolution of Risk Management, (B) Sovereign and Systemic Risk, (C) Liquidity, (D) Risk Management Principles and Strategies, (E) Credit Risk and (F) Equity Risk and Market Crashes. Oliviero Roggi, my co-organizer and the leading force behind the original concept for our Conferences, kick-starts with a contribution on the evolution of the concept of risk and risk management from Luca Pacioli until v

6 vi Foreword now. The chapter emphasizes both the historical evolution of the concept of risk in the economics literature and the most recent development of the risk management discipline after the financial crisis. Starting the chapter on Systemic and Sovereign Risk, Altman and Rijken propose and test a novel approach to assess the risk of default of sovereign debt the number one risk arena today in global markets. Their idea is to add to the traditional macro-economic indicators, e.g., debt/gdp ratio, a robust measure of the health of a nation s private sector. Starting with the non-financial corporate sector and then moving to the financial sector, the authors utilize their new Z-Metrics probability of default (PD) model for individual, listed companies in a dozen European countries, and in the U.S. They then choose a benchmark measure for each country, e.g., the median of a firm s PD, and examine the hierarchy of risk measures across countries, including the so-called PIIGS. Not surprisingly, countries like Greece and Portugal rank as the most risky, with Spain and Italy next. These rankings, however, were evident even before the risk and capital market indicators, like interest rates, credit agencies ratings, and CDS premiums, began to differentiate amongst the various Euro-currency countries. Their technique provides some encouragement to predicting sovereign crises going forward. Engle et al. provide a precise definition of the systemic risk that a firm, primarily banks, need in terms of its potential contribution to systemic failure. They postulate that systemic risk is particularly vulnerable when the aggregate capital is low. The focus of this chapter is on the expected capital shortfall of a firm in a crisis. The capital shortfall that the authors calculate for large international banks can also be used in the U.S. to conform to the requirement specified by Dodd Frank for annual stress tests of capital adequacy of financial firms either as a complement or substitute for existing tests. The chapter concludes with a list of the ten most systematically risky firms in the U.S. as of the end of Acharya et al. suggest that some financial institutions contribute more to the overall capital shortfall in a crisis and that this is an example of negative externalities of systemic risk in the financial sector. Since markets do not price these negative externalities, they typically go unchecked and get produced in excess. Hence, they argue that this risk be taxed, unlike the Dodd Frank study, which attempts to contain systemic risk through the design of capital adequacy requirements. Their approach is not a

7 Foreword vii straight-forward tax on either assets or liabilities, proposed by others, but through a public-private insurance plan that also provides incentives to limit systemic risk or to be well capitalized against systemic risk in order to reduce insurance costs. Moving to Liquidity Risk, Brenner and Schrieber examine the foreign exchange options market to assess its efficiency and liquidity. They assert that foreign exchange markets play a critical role in most economies, especially small-open ones. Hence, it is crucial that it is a liquid market, as highlighted in the recent financial crisis. Their chapter compares three related currency exchange markets (OTC trading, central bank option auctions and exchange traded ones) to provide insights on their effects on prices, arbitrage opportunities, and information for volatility forecasting. Finally, they also explore how FX spot and options markets are related. Subrahmanyam et al. investigate whether liquidity is an important factor in the pricing of the U.S. corporate bond market, especially whether liquidity effects are more pronounced during financial crises. Utilizing a wide range of liquidity measures, they conclude that liquidity effects account for about 14% of market-wide corporate yield-spread changes in general a modest but not trivial amount but significantly larger in periods of crisis and for speculative grade bonds. In a chapter on risk management principles and strategies, Zvi Bodie and Torben Andersen explore the fundamental principles and strategies for implementing an integrated risk management system for investors and for firms. Bodie emphasizes the importance of a truly risk-free, safe asset an increasingly illusive benchmark asset in a world where risk-free sovereign debt is the most troublesome risk-arena in today s uncertain global environment, especially in Europe. While Bodie s general principles reference is at the investment portfolio level, Andersen s is at the firm level. Andersen shows empirically that firms with effective risk management systems achieve positive relative performance through investment in innovation and by using lower levels of leverage. On the Credit Risk front, we have included three related chapters two on assessing the probability of default (PD) of small and medium-sized firms (SMEs) and one on Recovery Risk. Altman and Sabato examine the efficacy of developing a distress prediction model for SMEs with less than $65 million in sales in the U.S.A. The emphasis is on assisting banks to accommodate the Basel Accord s capital requirements for SMEs, which give

8 viii Foreword considerable capital requirement benefits to SMEs, especially with respect to specialized, internal rate-based models. Roggi and Giannozzi utilize both financial and qualitative data in their credit risk modeling for regional banks in Italy also on a SME population. They assess if these regional models are superior to national-based models a result which turns out to favor regionally-based approaches, especially due to local specificity variables, as well as industry specific ones. Frye and Jacobs, Jr. focus on systemic risk, not only of default probabilities, but of default loss. They acknowledge the problems with the nature and scarcity of Loss-Given-Default (LGD) data compared to PD data and concentrate on a simple, yet effective statistical approach. Building on the now established results that PD and LGD are systematically related (e.g., that defaults are negatively correlated with recoveries), they postulate that lenders should anticipate systematic LGD within their credit portfolio loss models. Finally, we turn to equity risk and the premiums that investors require over the various economic cycles, specifically in the period. Damodaran postulates that despite its importance in corporate finance and valuation, estimating equity risk premiums remains haphazard, in practice. He emphasizes that information uncertainty and perceptions of macroeconomic risk form investor risk aversion and required rates of return of equity investments vs. bonds (governments). He laments the lack of historical data, especially in emerging markets on these return comparisons, and suggests several techniques for estimating this premium, including: (1) surveys of investors and managers as to the assessment of risk premiums, (2) the estimation of these premiums from premiums in other, non-equity markets i.e., implied premiums, and (3) how the comparison between risk premiums in the equity market vs. premiums in the bond markets (default spreads) and the real estate market (capitalization rates) can be assessed to infer expected equity risk premiums. Ziemba and Lleoyz investigate the recent stock market crashes in several countries in the period. They use the bond vs. stock earnings yield differential model as a prediction tool for market crashes. They show that when the long-term bond yield is very high relative to the trailing earnings/price ratio of stocks, there is usually a crash within 4 12 months. This measure would have been especially predictive of the market crashes in China, Iceland and the U.S. around the economic crisis

9 Foreword ix of During this period, China s stock market dropped by 66%, that of Iceland by 95% and the U.S. by 57%. We hope to publish another book based on Keynote papers that would be presented at the forthcoming IRMC s conferences. E. I. Altman O. Roggi (June 2012)

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11 ABOUT THE EDITORS OLIVIERO ROGGI Dr. Oliviero Roggi is Professor of Corporate Finance at the University of Florence since In 2011, he joined New York University Stern School of Business as a Visiting Associate Professor of Finance where he taught Valuation, as part of Finance course, to MBA students. Dr. Roggi was a Visiting Scholar at NYU Stern in 2009, and a Salomon Center Research Fellow in In 2008, he partnered with Dr. Edward Altman of New York Stern School of Business to establish the International Risk Management Conference. Dr. Roggi has published papers and books on SME rating and general rating models. In 2009, he published Rischio, Valore e Insolvenza (Risk Value and Company Default, forthcoming in this series). He coauthored the third Italian edition of Applied Corporate Finance with Prof. Aswath Damodaran of New York Stern School of Business. He also coauthored the IFC World Bank handbook on risk management titled: Risk Taking: A Corporate Governance Perspective with Aswath Damodaran and Maxine Garvey. In 2007, he founded the Finanza Firenze Research Center. From 2008 to 2009, he was a Visiting Professor at Universidade de Fortaleza and a Visiting Researcher at City University Business School from 1998 to Dr. Roggi is a consultant for the European Commission, Regione Toscana (Italy) and other publicly owned entities, and has been conducting research in the area of enterprise risk management, particularly credit risk, since He is a member of the Scientific Committee of the Country Risk Forum of Associazione Bancaria Italiana (ABI Italian Bankers Association) and is the chairman and founder of The Risk Banking and Finance Society. He has also worked as a consultant at IFC World Bank Group since xi

12 xii About the Editors Dr. Roggi received his B.A. in Banking (with honors) from the University of Florence, and Ph.D. in Management and Finance from the University of Bologna and City University Business School (Joint Ph. D. program). EDWARD I. ALTMAN Dr. Edward Altman is the Max L. Heine Professor of Finance at the Stern School of Business, New York University, and Director of the Credit and Fixed Income Research Program at the NYU Salomon Center. Dr. Altman has an international reputation as an expert on corporate bankruptcy, high yield bonds, distressed debt and credit risk analysis. He was named Laureate 1984 by the Hautes Études Commerciales Foundation in Paris for his accumulated works on corporate distress prediction models and procedures for firm financial rehabilitation and awarded the Graham & Dodd Scroll for 1985 by the Financial Analysts Federation for his work on Default Rates and High Yield Corporate Debt. He was a Founding Executive Editor of the Journal of Banking & Finance. Professor Altman was inducted into the Fixed Income Analysts Society Hall of Fame in 2001 and elected President of the Financial Management Association (2003) and a Fellow of the FMA in 2004, and was amongst the inaugural inductees into the Turnaround Management Association s Hall of Fame in In 2005, Dr. Altman was named one of the 100 Most Influential People in Finance by Treasury & Risk Management magazine and is frequently quoted in the popular press and on network TV. Dr. Altman has been an advisor to many financial institutions including Merrill Lynch, Salomon Brothers, Citigroup, Concordia Advisors, Investcorp and the RiskMetrics Group, (MSCI,Inc.).HeisnowanAdvisorto Paulson & Co., a consultant to FINRA and he serves on the Board of the Franklin Series Funds. He is also Chairman of the Academic Advisory Council of the Turnaround Management Association. Dr.Altmanwasa Founding Trustee of the Museum of American Finance and was Chairman of the Board of the International Schools Orchestras of New York.

13 CONTENTS Foreword About the Editors Part A. The Evolution of Risk Management 1 Chapter 1. An Evolutionary Perspective on the Concept of Risk, Uncertainty and Risk Management 3 Oliviero Roggi and Omar Ottonelli Part B. Sovereign and Systemic Risk 39 Chapter 2. Toward A Bottom-Up Approach to Assessing Sovereign Default Risk: An Update 41 Edward I. Altman and Herbert Rijken Chapter 3. Measuring Systemic Risk 65 Viral V. Acharya, Christian Brownlees, Robert Engle, Farhang Farazmand and Matthew Richardson v xi Chapter 4. Taxing Systemic Risk 99 Viral V. Acharya, Lasse Pedersen, Thomas Philippon and Matthew Richardson Part C. Liquidity 123 Chapter 5. Liquidity and Efficiency in Three Related Foreign Exchange Options Markets 125 Menachem Brenner and Ben Z. Schreiber xiii

14 xiv Contents Chapter 6. Illiquidity or Credit Deterioration: A Study of Liquidity in the US Corporate Bond Market During Financial Crises 159 Nils Friewald, Rainer Jankowitsch and Marti G. Subrahmanyam Part D. Risk Management Principles and Strategies 201 Chapter 7. Integrated Wealth and Risk Management: First Principles 203 Zvi Bodie Chapter 8. Analyzing the Impact of Effective Risk Management: Innovation and Capital Structure Effects 215 Torben Juul Andersen Part E. Credit Risk 249 Chapter 9. Modeling Credit Risk for SMEs: Evidence from the US Market 251 Edward I. Altman and Gabriele Sabato Chapter 10. SME Rating: Risk Globally, Measure Locally 281 Oliviero Roggi and Alessandro Giannozzi Chapter 11. Credit Loss and Systematic LGD 307 Jon Frye and Michael Jacobs Jr. Part F. Equity Risk and Market Crashes 341 Chapter 12. Equity Risk Premiums (ERP): Determinants, Estimation and Implications The 2012 Edition 343 Aswath Damodaran Chapter 13. Stock Market Crashes in : Were We Able to Predict Them? 457 Sébastien Lleo and William T. Ziemba About The Risk, Banking and Finance Society About the International Risk Management Conference

CALL FOR PAPERS. New Dimensions in Risk Management IRMC Fourth Edition

CALL FOR PAPERS. New Dimensions in Risk Management IRMC Fourth Edition Amsterdam, Netherlands: June 14 th - 15 th, 2011 VU School of Finance & Risk Management VU University of Amsterdam CALL FOR PAPERS New Dimensions in Risk Management IRMC Fourth Edition The following questions