Dale F. Gray

A New Framework for Analyzing and Managing Macrofinancial Risks of an Economy

The high cost of international economic and financial crises highlights the need for a comprehensive framework to assess the robustness of national economic and financial systems. This paper proposes a new comprehensive approach to measure, analyze, and manage macroeconomic risk based on the theory and practice of modern contingent claims analysis (CCA). We illustrate how to use the CCA approach to model and measure sectoral and national risk exposures, and analyze policies to offset their potentially harmful effects. This new framework provides economic balance sheets for inter-linked sectors and a risk accounting framework for an economy. CCA provides a natural framework for analysis of mismatches between an entitys assets and liabilities, such as currency and maturity mismatches on balance sheets. Policies or actions that reduce these mismatches will help reduce risk and vulnerability. It also provides a new framework for sovereign capital structure analysis. It is useful for assessing vulnerability, policy analysis, risk management, investment analysis, and design of risk control strategies. Both public and private sector participants can benefit from pursuing ways to facilitate more efficient macro risk accounting, improve price and volatility discovery, and expand international risk intermediation activities.

The Contingent Claims Approach to Corporate Vulnerability Analysis: Estimating Default Risk and Economy-Wide Risk Transfer

In this paper, we examine the ability of the contingent claims approach (CCA) to identify corporate sector and economy-wide vulnerabilities. We apply the Moody`s M/Risk model, which uses aggregated CCA principles, to assess vulnerabilities retroactively in two historical country cases. The results indicate that the method may prove helpful in identifying corporate sector vulnerabilities and estimating the associated value of risk transfer across interrelated balance sheets of the corporate, financial, and public sectors.

On a New Approach for Analyzing and Managing Macrofinancial Risks

At the fifth annual CFA Institute European Investment Conference on 19 October 2012 in Prague, Robert C. Merton gave a presentation on analyzing and managing macrofinancial risk. This article is based on his talk and on research he carried out with his coauthors. A framework for measuring and analyzing macrofinancial risk, particularly financial system credit risk and sovereign credit risk, is described, along with how one might go about monitoring the connections. The data suggest that the degree of connectedness across different types of financial institutions and sovereigns changes considerably over time. Current financial system models used by economists and central banks to assess and manage economies are generally not capable of accurately analyzing and managing the macrofinancial risks because they do not incorporate the fundamental nonlinear structures of credit risks. As a result, they cannot measure the changing degree of connectedness among financial institutions and sovereigns. A new approach for analyzing and managing macrofinancial risks is needed, particularly one that integrates monetary, fiscal, and financial stability policies and accounts for interconnectedness and risk transmission. At the fifth annual CFA Institute European Investment Conference on 19 October 2012 in Prague, Robert C. Merton gave a presentation on analyzing and managing macrofinancial risk. This article is based on his talk and on research he carried out with his coauthors. Editor’s Note: Much of the research discussed herein is from the paper “Sovereign, Bank, and Insurance Credit Spreads: Connectedness and System Networks,” by M. Billio, M. Getmansky, D. Gray, A. Lo, R.C. Merton, and L. Pelizzon, MIT working paper (forthcoming 2013). Authors’ Note: This article was accepted before 3 February 2013.

International Transmission of Bank and Corporate Distress

The paper evaluates how increases in banks’ and nonfinancial corporates’ default risk are transmitted in the global economy, using in a vector autoregression model for 30 advanced and emerging economies for the period from January 1996 to December 2008. The results point to two-way causality between bank and corporate distress and to significant global macroeconomic and financial spillovers from either type of distress when it originates in a systemic economy. Corporate distress in advanced economies has a larger impact on economic growth in emerging economies than bank distress in advanced economies has. In contrast, activity in advanced economies is more vulnerable to bank distress than to corporate distress.

A Risk-Based Debt Sustainability Framework; Incorporating Balance Sheets and Uncertainty

This paper proposes a new framework for the analysis of public sector debt sustainability. The framework uses concepts and methods from modern practice of contingent claims to develop a quantitative risk-based model of sovereign credit risk. The motivation in developing this framework is to provide a clear and workable complement to traditional debt sustainability analysis which-although it has many useful applications-suffers from the inability to measure risk exposures, default probabilities and credit spreads. Importantly, this new framework can be adapted for policy analysis, including debt and reserve management.

Modeling Banking, Sovereign, and Macro Risk in a CCA Global VAR

The purpose of this paper is to develop a model framework for the analysis of interactions between banking sector risk, sovereign risk, corporate sector risk, real economic activity, and credit growth for 15 European countries and the United States. It is an integrated macroeconomic systemic risk model framework that draws on the advantages of forward-looking contingent claims analysis (CCA) risk indicators for the banking systems in each country, forward-looking CCA risk indicators for sovereigns, and a GVAR model to combine the banking, the sovereign, and the macro sphere. The CCA indicators capture the nonlinearity of changes in bank assets, equity capital, credit spreads, and default probabilities. They capture the expected losses, spreads and default probability for sovereigns. Key to the framework is that sovereign credit spreads, banking system credit risk, corporate sector credit risk, economic growth, and credit variables are combined in a fully endogenous setting. Upon estimation and calibration of the global model, we simulate various negative and positive shock scenarios, particularly to bank and sovereign risk. The goal is to use this framework to analyze the impact and spillover of shocks and to help identify policies that would mitigate banking system, sovereign credit risk and recession risk—policies including bank capital increases, purchase of sovereign debt, and guarantees.

Incorporating Financial Sector Risk into Monetary Policy Models: Application to Chile

This article analyzes whether market-based financial stability indicators (FSIs) should be included in monetary policy models and, if so, how.1 Since the economy and interest rates affect financial sector credit risk, and the financial sector affects the economy, this article builds a model of financial sector vulnerability and integrates it into a macroeconomic framework, typically used for monetary policy analysis. More specifically, should the central bank explicitly include the financial stability indicator in its monetary policy (interest rate) reaction function? This is the most important question to be answered in this article. The alternative would be to react only indirectly to financial risk by reacting to inflation and gross domestic product (GDP) gaps, since they already include the effect that financial factors have on the economy.

Evaluation of Taxes and Revenues from the Energy Sector in the Baltics, Russia, and Other Former Soviet Union Countries

This paper examines the level and structure of fiscal revenues from the Baltics, Russia, and other former Soviet Union countries` (BRO) energy sector and suggests reforms in energy tax policy. Revenues from the oil and gas sectors are about half the level that might be expected from international comparisons. Low oil revenues result from infrastructure constraints on oil exports, weak tax administration, and inappropriate tax structures. Low gas revenues are due to low statutory tax rates, a tax structure that does not capture monopoly or resource rents, and weak tax administration. Taxation of oil products could be increased.

Systemic Contingent Claims Analysis

This chapter introduces a new framework for macroprudential analysis using a riskadjusted balance sheet approach that supports policy eff orts aimed at mitigating systemic risk from linkages between institutions and the extent to which they precipitate or amplify general market distress. In this regard, a forwardlooking framework for mea sur ing systemic solvency risk using an advanced form of contingent claims analysis (CCA), known as “Systemic CCA,” is presented for the systemwide capital assessment in topdown stress testing. The magnitude of joint default risk of multiple fi nancial institutions falling into distress is modeled as a portfolio of individual marketimplied expected losses (with individual risk pa rame ters) calculated from equity market and balance sheet information. An example of Systemic CCA applied to the U.K. banking sector delivers useful insights about the magnitude of systemic losses in the context of macroprudential stress testing. In addition, the framework also helps quantify the individual contributions of institutions to systemic risk of the fi nancial sector during times of stress.