Yoram Landskroner

Interest rate risk subsidization in international capital standards

In setting capital standards on the basis of credit risk alone, the Basle Accord does not consider other types of risk such as interest rate risk. In this paper, we empirically investigate the impact of this implicit interest rate risk subsidy on bank risk-taking behavior. In the post-Accord period, we find that 20% of banks have excessive levels of on-balance sheet duration gaps which exceed 1% of total assets. Our empirical evidence supports an argument that banks have substituted unpriced interest rate risk for priced credit risk in their portfolios to take advantage of an interest rate risk subsidy under the Basle Accord. Banks which were exposed to significant levels of interest rate risk in the post-Accord period tend to be smaller, less active in off-balance sheet activities, have smaller credit risk exposure and higher risk-based capital ratios, but have lower capital to asset (leverage) ratios than other banks. Although the observed decline in credit risk and increase in interest rate risk may be the result of factors which have nothing to do with capital requirements, the magnitude of the shifts suggests the importance of pricing interest rate risk in risk-based capital regulations.

Risk Premia and the

THE PROCESS OF INFLATION is associated not only with a rising general price level, but also with uncertainty about its rate of change. It is the latter aspect of inflation that may give rise to risk premia on nominal assets as compared with a real safe asset. A possible framework for analyzing the structure of risk premia under inflationary conditions is the well-known Capital Asset Pricing Model (CAPM) developed by Sharpe and Lintner. Indeed, a number of papers have recently dealt with these risk premia by means of the CAPM framework or some close variety of it. We may mention the works of Roll [9], Sarnat [10], Fischer [4], Chen and Boness [1], and Friend, Landskroner, and Losq [5].1 The CAPM and its extentions to conditions of inflation use a microeconomic approach in a partial equilibrium analysis of the risk premia. A basic feature of the foregoing literature is the implicit treatment of inflation as exogenous. Alternatively, there is no theory to relate the real return on money (to be denoted 7r) to the other variables in the CAPM formulation. This leads to two important shortcomings. First, the covariance of 7r with the rates of return appears as completely arbitrary. Second, since X was considered as exogenous, the authors did not consider the need to include in their models the governments nominal transfer pay-

Nonmarketable Assets and the Determinants of the Market Price of Risk

T he original capital asset pricing model (hereafter CAPM) developed by Sharpe (1964), Lintner (1965) and Mossin (1966) was advanced to explain the return differential between risky assets and a risk-free asset under conditions of uncertainty. The model demonstrates that in equilibrium the return differential on a risky asset is determined by two factors: the market price of (unit) risk (hereafter MPR) which is common to all risky assets, and a risk factor unique to each asset. The equilibrium return differential is

Inflation Uncertainties and Returns on Bonds

The new wave of research on the effect of inflation on interest rates revolves around the incorporation of inflation uncertainty into the analysis.1 In a recent paper, Liviatan and Levhari (1977) examine in a single-period model the market risk premium on nominal bonds awarded as compensation for inflation-related uncertainty, where this premium is determined by attitudes of investors towards risk and the risk of inflation. The hypothesis that nominal bonds carry an inflation uncertainty premium could be extended to multi-period bonds. This is also consistent with Hicks (1946) liquidity premium, which was estimated by Kessel (1965) and McCullough (1975), who found systematic premia on the average returns of multi-period bonds.2 This study too is concerned with the possible relationships between inflation uncertainties and the returns on multi-period bonds. We are examining the hypotheses using ex ante data and measures of inflation uncertainty based on these data. The two sources of inflation uncertainty that may be associated with the returns on multi-period bonds are the uncertainty about the rate of inflation in the next period, and the uncertainty about expectations of inflation in future periods. For a bond with two periods to maturity, the holding period return is

Venture capital: Structure and incentives

Abstract Venture capital is a major source of financing for firms in their early stages of development. Such businesses, especially in the high technology industries, are characterized by a high degree of uncertainty and asymmetry of information. In this paper we analyze the relationship between a venture capital organization (“capitalist”) and the initial owner of an entrepreneurial entity in which it invests (“entrepreneur”). We focus on the agency problems and derive a compensation system. In our model the capitalist provides a combination of equity and debt financing while the owner provides equity financing which serves as a signal affecting the beliefs (“optimism”) of the capitalist. The interesting result is that since the capitalist is assumed to be more risk averse than the entrepreneur, he is made to be more optimistic than the entrepreneur at the optimum.

A Balance Sheet Approach for Sovereign Debt

A sovereign that is issuing debt denominated in foreign currency is exposed to a mismatch between the value of its assets that can be used to serve the debt, denominated in local currency, and the value of its liability. During economic crisis, when the probability of default by the sovereign increases, there is a tendency for the exchange rate to experience sudden shock. Such a relationship has been observed in most of the recent financial crises in emerging markets (for example, in the East Asian crisis of 1997 and the Russian debt crisis of 1998). In this paper we develop a structural model for pricing sovereign debt that is denominated in foreign currency where the effect of local economic crisis on the exchange rate is considered through a state-dependent jump intensity variable that is sensitive to the distance of default of the sovereign debt. The presented pricing model can produce a higher credit spread than the classical Merton-based approach (1974) for risky debt. The model can help traders, risk managers, accountants, and policymakers who are interested in more accurately evaluating the fair value of sovereign debt that is denominated in foreign currency.

Deposit insurance pricing and social welfare

Abstract Recent literature has established that financial disruption has real costs which justify government intervention in the financial sector. One form of government intervention is deposit insurance. In this paper we determine the optimal pricing and subsidy of deposit insurance in a social welfare context. The main conclusion is that optimal deposit insurance need not be actuarially fair. In an economy with a real and a financial sector we consider the effects of taxation and social (political) weights of the sectors. We analyze two policy tools: government supervision and deposit insurance pricing.

Inflation, depreciation and optimal production

Abstract Depreciation is an economic outlay, though not a cash outflow. It is recognized as an outlay for tax purposes. This paper deals only with the tax effect of the depreciation method, emphasizing the impact of inflation on both the optimal depreciation method and optimal combination of production factors chosen by firms. In the U.S. and other countries accelerated forms of depreciation were adopted. These methods are analyzed and an optimal one is proposed.

New money and adjustment policies

Abstract This paper deals with a particular version of the debt-overhang problem. The paper models the debt renegotiation process between a sovereign borrower and a commercial lender in a game-theoretic framework. The objective of the paper is to model and examine how a neutral third party (such as the IMF) can help to resolve conflicts between the international borrower and lender and can credibly enforce a Pareto superior solution. The relationship between the actions of the two parties: new money by the lender and adjustment policies of the borrower—is the basis for the model. The parameters of this relationship are established by the third party. The relevant decisions in the model are second best solutions that take into account the interdependence of the actions of the borrower and the lender.

Optimal Regulation, Executive Compensation and Risk Taking by Financial Institutions

We present an equilibrium model of financial institutions in which we examine the optimal regulation of risk taking. Choice of risk levels result from strategic interactions of regulators, shareholders, and management. Regulators use caps on asset risk and equity-based compensation to achieve the optimal level of risk; shareholders choose levels of managements stock ownership; and management chooses asset risk. We characterize the socially optimal level of risk. If there is perfect information and enforcement, using one policy tool is sufficient. If enforcement is limited or information is asymmetric, there can be gains to social welfare from employing both policy tools.