Simone Varotto

Liquidity Risk, Credit Risk, Market Risk and Bank Capital

With a sample of twelve US bond indices spanning different maturities, credit ratings and industry sectors, we investigate the impact of new bank capital regulation for trading portfolios introduced by Basel III. Specifically, we estimate the new capital requirements for (a) liquidity risk and credit risk through the so called Incremental Risk Charge, and (b) the risk of extreme market movements, which we measure with stress tests based on the 2007-2009 financial crisis. We find that capital requirements should increase substantially more than suggested by extensive impact studies conducted by the regulators with the participation of a large sample of banks. We suggest that the lower impact on capital reported by the banks may be due to the assumed risk reduction stemming from their hedging strategies. However, their effectiveness in crisis scenarios remains an open question.

Timeliness of Spread Implied Ratings

Rating agencies are known to be prudent in their approach to rating revisions, which results in delayed rating adjustments. For a large set of eurobonds we derive credit spread implied ratings and compare them with agency ratings. Our results indicate that spread implied ratings often anticipate the future movement of agency ratings and hence can help track credit risk in a more timely manner. This finding has important implications for risk managers in banks who, under the new Basel 2 regulations, have to rely more on credit ratings for capital allocation purposes, and for portfolio managers who face rating-related investment restrictions.

Value at Risk and Precommitment: Approaches to Market Risk Regulation

This paper examines whether principal agent problems between the shareholders and the managers in banks would undermine the use of a capital regime relying on incentives for the shareholders.

An assessment of the internal rating based approach in Basel II

The new bank capital regulation commonly known as Basel II includes a internal rating based approach (IRB) to measuring credit risk in bank portfolios. The IRB relies on the assumptions that the portfolio is fully diversified and that systematic risk is driven by one common factor. In this work we empirically investigate the impact of these assumptions by comparing the risk measures produced by the IRB with those of a more general credit risk model that allows for multiple systematic risk factors and portfolio concentration. Our tests conducted on a large sample of eurobonds over a ten year period reveal that deviations between the IRB and the general model can be substantial.

Is Small Beautiful? The Resilience of Small Banks During the European Debt Crisis

We examine the lending behaviour of small and large banks in the Eurozone during the sovereign debt crisis. Relative to large banks, small banks are less pro-cyclical in that they exhibit more stable lending growth across credit expansion and contraction periods. In peripheral countries, the portfolio rebalancing of small banks towards higher public debt (substitution effect) does not appear to cause a reduction of their lending to the private sector. Instead, the level of public debt seems to provide a liquidity buffer that influences bank-specific loan growth positively (complementarity effect), particularly during market-wide lending contractions. Our findings show that for small peripheral banks the substitution effect documented in the literature can coexist with a complementarity effect when public debt grows faster than private loans. Our analysis contributes to the ongoing debate on the regulatory treatment of public debt in banks and supports incentives embedded in new banking regulation that penalise bank size.

Liquidity and Shadow Banking

Using a unique dataset of detailed portfolio holdings of US money market funds, we study the funds’ behavior in the context of the European sovereign debt crisis. These important players in the shadow banking sector were particularly vulnerable to liquidity shocks before the introduction of minimum liquidity requirements. We analyze the impact of these requirements and show that they have considerably increased the resilience of prime funds. We also see that funds increase their liquidity to counter uncertainty in investors’ redemptions. But, liquidity does not shelter risky funds from lower inflows.