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| Working Papers – 2004 |
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Risk-Based Capital Standards, Deposit Insurance and Procyclicality FDIC Center for Financial Research Working Paper No. 2004-05 This Version: November 2004 Published as: Pennacchi, George G. "Risk-Based Capital Standards, Deposit Insurance and Procyclicality." Journal of Financial Intermediation 14, no. 4 (2005): 432-465. Abstract This article shows that risk-based deposit insurance premiums generate smaller procyclical effects than do risk-based capital requirements. Thus, Basel II's procyclical impact can be reduced by integrating risk-based deposit insurance. If deposit insurance is structured as a moving average of contracts, its procyclical effects can be decreased further. Empirical illustrations of this are presented for 42 banks over the period 1987 to 1996. The results confirm that lengthening the contracts maturities intertemporally smooths premiums but raises the average premium level needed to compensate the insurer for greater systematic risk. The distribution of risk-based premiums across banks is skewed. JEL Classification: G21; G22; G28 |
Common Failings: How Corporate Defaults are Correlated FDIC Center for Financial Research Working Paper No. 2004-04 This Version: September 2004 Published as: Das, Sanjiv R., Darrell Duffie, Nikunj Kapadia, and Leandro Saita. "Common failings: How corporate defaults are correlated." The Journal of Finance 62, no. 1 (2007): 93-117. Abstract We develop, and apply to data on U.S. corporations from 1987-2000, tests of the standard doubly-stochastic assumption under which firms' default times are correlated only as implied by correlation of their default intensity processes, for example through dependence on common or correlated observable risk factors. Our tests do not require assumptions on the correlation structure of default intensities. The data do not support the joint hypothesis of well specified default intensities and the doubly stochastic assumption, although we provide evidence that this may be due to mis-specification of the default intensities, which do not include macroeconomic default-prediction covariates. Despite this rejection, there is at most weak evidence of default clustering in excess of that implied by the doubly-stochastic model and correlation of the firm-specific default covariates. JEL Classification: G18, G14 |
What Caused the Bank Capital Build-up of the 1990s? FDIC Center for Financial Research Working Paper No. 2004-03 This Version: August 2004 Published as: Flannery, Mark J. and Kasturi P. Rangan. "What caused the bank capital build-up of the 1990s?" Review of Finance 12, no. 2 (2008): 391-429. Abstract Large U.S. banks dramatically increased their capitalization during the 1990s, to the highest levels in more than 50 years. We document this buildup of capital and evaluate several potential motivations. Our results support the hypothesis that regulatory innovations in the early 1990s weakened conjectural government guarantees and enhanced the bank counterparties incentive to monitor and price default risk. We find no evidence that a bank holding company's market capitalization increases with its asset volatility prior to 1994. Thereafter, the data display a strong cross-sectional relation between capitalization and asset risk. Our estimates indicate that most of the bank capital buildup over the sample period can be explained by greater bank risk exposures and the market's increased demand that large banks' default risk be priced. JEL Classification: G18, G14 |
Capital Adequacy and Basel II FDIC Center for Financial Research Working Paper No. 2004-02 This Version: December 2004 Abstract Using a one common factor Black-Scholes-Merton (BSM) equilibrium model of credit risk, this paper derives unbiased capital allocation rules for portfolios in which idiosyncratic risk is fully diversified. When these rules are compared with the Basel II Internal Ratings Based (IRB) minimum capital requirements for corporate exposures, the comparison shows that the Basel Advanced IRB (A-IRB) approach drastically undercapitalizes portfolio credit risk relative to the supervisory target of a 99.9 percent bank solvency rate. Estimates show that Basel regulations will allow fully compliant A-IRB banks to have default rates that exceed 5 percent. In contrast, the Foundation IRB minimum capital requirements allocate multiple times the capital necessary to achieve the supervisory objective. These results raise a number of important issues including the potential for increased systemic risk as regulatory capital rules promote banking sector consolidation and poor risk management standards in A-IRB banks. JEL Classification: G12, G20, G21, G28 |
Risk-Neutralizing Statistical Distributions: With an Application to Pricing Reinsurance Contracts on FDIC Losses FDIC Center for Financial Research Working Paper No. 2004-01 This Version: September 2004 Abstract This paper proposes methods for obtaining risk neutral distributions when only the statistical density is observed. We employ renormalized exponential tilts and estimate the tilt coefficients from related options markets. Particular emphasis is placed on reinsurance losses for which we price in closed form using the Weibull extreme value distribution. The procedure is illustrated in detail for FDIC losses. CFR research programs: risk measurement, deposit insurance |
The Center for Financial Research (CFR) Working Paper Series allows CFR staff and their coauthors to circulate preliminary research findings to stimulate discussion and critical comment. Views and opinions expressed in CFR Working Papers reflect those of the authors and do not necessarily reflect those of the FDIC or the United States. Comments and suggestions are welcome and should be directed to the authors. References should cite this research as a “FDIC CFR Working Paper” and should note that findings and conclusions in working papers may be preliminary and subject to revision.