Paul H. Kupiec

Noise Traders, Excess Volatility, and a Securities Transactions Tax

Proponents of a securities transactions tax have suggested that such a tax may reduce stock return volatility. The argument is that, to the extent that short-term speculative trading volume is the source of excess volatility, a tax that reduces such volume will reduce volatility. In the context of a simple general equilibrium model, it is shown that this partial equilibrium argument is misleading and in large part incorrect. In the absence of a tax, the model generates equilibria in which the risky assets price exhibits excess volatility and agents engage in excess trading activity owing to the presence of destabilizing noise traders. Within the context of the model, it is shown that, although a transactions tax can reduce the volatility of the risky assets price, the reduction in price volatility is accompanied by a fall in the assets price as agents discount the future tax liability associated with risky asset ownership. Consequently, although price volatility may decrease slightly, the fall in equilibrium prices more than compensates, and the volatiltiy of risky asset returns unambiguously increases with the level of the transactions tax.

Regulatory competition and the efficiency of alternative derivative product margining systems

Although margin requirements would arise naturally in the context of unregulated trading of clearinghouse-guaranteed derivative contracts, the margin requirements on U.S. exchange-traded derivative products are subject to government regulatory oversight. At present, two alternative methodologies are used for margining exchange-traded derivative contracts. Customer positions in securities and securities options are margined using a strategy-based approach. Futures, futures-options, and securities-option clearinghouse margins are set using a portfolio margining system. This study evaluates the relative efficiency of these alternative margining techniques using data on S&P500 futures-option contracts traded on the Chicago Mercantile Exchange. The results indicate that the portfolio margining approach is a much more efficient system for collateralizing the one-day risk exposures of equity derivative portfolios. Given the overwhelming efficiency advantage of the portfolio approach, the simultaneous existence of these alternative margining methods is somewhat puzzling. It is argued that the co-existence of these systems can in part be explained in the context of Kanes (1984) model of regulatory competition. The efficiency comparison also provides insight into other industry and regulatory issues including the design of bilateral collateralization agreements and the efficiency of alternative schemes that have been proposed for setting regulatory capital requirements for market risk in banks and other financial institutions.

The New Basel Capital Accord: The Devil Is in the (Calibration) Details

This paper considers characteristics of the capital requirements proposed in The New Basel Capital Accord (2001). Formal analysis identifies calibration features that could give rise to unintended consequences that may include: concentration of credit risk in institutions that are less well equipped to measure and manage risks; an overabundance of thinly capitalized high quality long-maturity credits in foundation Internal Ratings-Based (IRB) banks; distortions in the secondary market for discount or premium credits; an increase in the difficulty of resolving distressed financial institutions; and incentives to distort the accuracy of loan loss provisions.

Testing for Systemic Risk Using Stock Returns

The literature proposes several stock return-based measures of systemic risk but does not include a classical hypothesis tests for detecting systemic risk. Using a joint null hypothesis of Gaussian returns and the absence of systemic risk, we develop a hypothesis test statistic to detect systemic risk in stock returns data. We apply our tests on conditional value-at-risk (CoVaR) and marginal expected shortfall (MES) estimates of the 50 largest US financial institutions using daily stock return data between 2006 and 2007. The CoVaR test identifies only one institution as systemically important while the MES test identifies 27 firms including some of the financial institutions that experienced distress in the past financial crisis. We perform a simulation analysis to assess the reliability of our proposed test statistics and find that our hypothesis tests have weak power, especially tests using CoVaR. We trace the power issue to the inherent variability of the nonparametric CoVaR and MES estimators that have been proposed in the literature. These estimators have large standard errors that increase as the tail dependence in stock returns strengthens.

Taking the Risk Out of Systemic Risk Measurement

An emerging literature proposes using conditional value at risk (CoVaR) and marginal expected shortfall (MES) to measure financial institution systemic risk. We identify two weaknesses in this literature: (1) it lacks formal statistical hypothesis tests; and, (2) it confounds systemic and systematic risk. We address these weaknesses by introducing a null hypothesis that stock returns are normally distributed. This allows us to separate systemic from systematic risk and construct hypothesis tests for the presence of systemic risk. We calculate the sampling distribution of these new test statistics and apply our tests to daily stock returns data over the period 2006-2007. The null hypothesis is rejected in many instances, consistent with tail dependence and systemic risk but the CoVaR and MES tests often disagree about which firms are potentially “systemic.” The highly restrictive nature of the null hypothesis and the wide range of firms identified as systemic makes us reluctant to interpret rejections as clear evidence of systemic risk. The

Basel II: A Case for Recalibration

Objectives for Basel II include the promulgation of a sound standard for risk measurement and risk-based minimum capital regulation. The AIRB approach, which may be mandatory for large U.S. banks, will give rise to large reductions in regulatory capital. This paper assess whether the reductions in minimum capital are justified by improvements in the accuracy of risk measurement under Basel II. Review of credit loss data and analysis of the economics of capital allocation methods identify important shortcomings in the AIRB framework that lead to undercapitalization of bank credit risks.

Incentive Compensation for Risk Managers When Effort is Unobservable

In a stylized model of a financial intermediary, risk managers expend costly effort to reduce loan PD and LGD. When effort is unobservable, incentive compensation (IC) can induce manager effort, but underwriting and loss mitigation managers require different IC contracts. Subsidized insured deposit funding decreases the demand for risk management because it decreases the insurance subsidy. When IC is required to induce effort, it further increases the principal’s costs because wages which are subsidized by the insurer are replaced with IC which is not. These additional costs reduce the principal’s demand for risk management and discourage IC contracts. Regulatory policy should reinforce an insured depository’s incentives to offer appropriate risk management IC contracts and yet existing regulatory guidance explicitly discourages performance-linked IC for risk managers.

Internal Models-Based Capital Regulation and Bank Risk-Taking Incentives

Advocates for internal model-based capital regulation argue that this approach will reduce costs and remove distortions that are created by rules-based capital regulations. These claims are examined using a Merton-style model of deposit insurance. Analysis shows that internal model-based capital estimates are biased by safety-net-generated funding subsidies that convey to bank shareholders when market and credit risk regulatory capital requirements are set using bank internal model estimates. These subsidies are not uniform across the risk spectrum, and, as a consequence, internal model regulatory capital requirements will cause distortions in bank lending behavior.

The leverage ratio is not the problem

Recent proposals have recommended important modifications to the supplemental leverage ratio (SLR) to promote the production of market liquidity and other beneficial banking activities that are alleged to have declined because of the introduction of Basel III capital regulations. A much better solution for promoting liquidity is to significantly raise the minimum SLR to minimize the debt-overhang problem and revise the deposit insurance pricing system so that premiums are much closer to fair market prices for the insurance.

Capital for concentrated credit portfolios

Most credit portfolios contain obligor concentration risk and yet international bank regulatory capital rules and many industry models assume perfect diversification. Multiple methods are available to calculate the approximate capital needs of a concentrated credit portfolio, but many of these involve advanced mathematical arguments, substantial computation time, and fail to clearly identify the most important credits causing concentration risk. In this article, I illustrate three approaches for calculating loss distributions and value-at-risk capital requirements. Of these, the large exposure approach proposed by Kupiec (2015) is especially easy to implement. It produces accurate estimates of the economic capital required for a concentrated portfolio and immediately identifies the obligors most responsible for generating concentration risk.