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Forward-looking asset correlations in the estimation of economic capital

Author

Listed:
  • Álvaro Chamizo

    (BBVA.)

  • Alexandre Fonollosa

    (BBVA.)

  • Alfonso Novales

    (Instituto Complutense de Análisis Económico (ICAE), and Department of Economic Analysis, Facultad de Ciencias Económicas y Empresariales, Universidad Complutense, 28223 Madrid, Spain.)

Abstract

We analyze whether the credit market anticipated the financial crisis before the regulators using a methodology that combines the Merton model for the determination of economic capital with Vasicek’s factor model for asset correlation. Contrary to standard practice, we estimate the credit value at risk (VaR) and expected shortfall (ES) of a global loan portfolio using CDS spreads because credit derivat- ives incorporate forward-looking information on future systemic shocks that might be essential in the estimation of economic capital. We find that one-factor model can generally be a good representation of correlations in the credit market because of the high inter-sector correlations, although an appro- priately chosen second factor can provide additional information for risk estimation in stressed times. We show that there were, indeed, signs of stress in the credit market that were not incorporated in the determination of economic capital during the crisis and that some financial institutions did not con- sider properly. The overall impression is that it is not so much that risk models were over-simplified to anticipate the financial crisis but rather, that they were backward-looking. A potential implication of our research is that the level of regulatory capital should react to events in the credit market.

Suggested Citation

  • Álvaro Chamizo & Alexandre Fonollosa & Alfonso Novales, 2019. "Forward-looking asset correlations in the estimation of economic capital," Documentos de Trabajo del ICAE 2019-25, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico.
    • Handle: RePEc:ucm:doicae:1925
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    References listed on IDEAS

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    1. Álvaro Chamizo & Alfonso Novales, 2019. "Market risk when hedging a global credit portfolio," Documentos de Trabajo del ICAE 2019-28, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico.

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    More about this item

    Keywords

    Forward-looking Asset Correlation; Economic Capital; Asset Allocation; Systemic Risk.;
    All these keywords.

    JEL classification:

    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • G01 - Financial Economics - - General - - - Financial Crises
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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