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Macrofinancial Risk: Fundamental Concepts and the Current International Context

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### Macrofinancial Risk: Fundamental Concepts and the Current International Context

Dale Gray

Monetary and Capital Markets Department

International Monetary Fund

The views expressed in this presentation are those of the author and should not be attributed to the International Monetary Fund, its Executive Board, or its management.

Macrofinancial Risk Analysis

- Framework integrates risk-adjusted balance sheets using Contingent Claims Analysis (CCA) with macroeconomic and monetary policy models
- CCA models of financial institutions, corporates, and sovereigns are integrated together and with macroeconomic models

Outline

- Contingent Claims Analysis (CCA)
- CCA Models of Financial Institutions (Moody’sKMV)
- Credit Turmoil and Financial Stability Risks
- Venezuelan Bank Sector Risk (MKMV)
- Global Spillovers to EM Corporates and Banks
- Based on papers by Dale Gray, Robert C. Merton and Zvi Bodie in: (i) JOIM 2007, (ii) NBER 2007; (iii) papers with Samuel Malone and new book on Macrofinance (2008); IMF GFSR 2008.

Core Concept: Merton Model/CCA for Firms and Banks

- Value of liabilities derived from value of assets.
- Liabilities have different seniority.
- Randomness in asset value.

- Assets = Equity + Risky Debt
- = Equity + Default-Free Debt – Expected Loss
- = Implicit Call Option + Default-Free Debt – Implicit Put Option

Equity or Jr Claims

Assets

Risky Debt

CCA Credit Risk Measures

Asset

Value

Exp. asset

Distribution of Asset Value

value path

Distance to

Distress: standard deviations asset value is from debt distress barrier

V

0

Distress Barrier

or promised payments

Probability of Default

T

Time

Summary of CCA and Credit Risk Indicators

- Value of Risky Debt, D (A= asset, σ=asset volatility B=distress barrier, P=implicit put option)
- Default Probability
- Risk Neutral DP
- Estimated Actual DP

Calibrating Implied Assets and Asset Volatility

- Implied asset value and implied asset volatility calibrated from contingent claims analysis.
- Merton Model
- Moody’s-KMV for firms and financial institutions
- Merton-type CCA or hybrid models have been applied to corporates and financial institutions. Moody’sKMV, Kamakura and others have applied these models for credit risk analysis to tens of thousands of firms and banks in over 50 countries around the world.
- Sovereign CCA uses local currency liabilities and debt structure to imply sovereign assets and asset volatility, used to then get risk indicators such as spreads on foreign and local currency sovereign debt, default probabilities (MfRisk has been applied to 22 countries).

INPUTS

Value and Volatility of Market Capitalization, E

Debt Distress Barrier B(from Book Value)

Time Horizon

Calibrate (Unobservable) Market Value of Asset and Implied Asset VolatilityUSING TWO EQUATIONS WITH TWO UNKNOWNS

Gives:

Implied Asset

Value A and

Asset Volatility A

Default Probabilities

Spreads, Risk Indicators

KMV maps risk indicators to actual default probabilities (EDFs) using historical default data

Using CCA MKMV Models to Analyze the Global Crisis

- Overview of subrime and related losses
- Sharp increases in spreads of banks with and without subprime exposure
- Drivers of increased default probabilites for banks in US and Europe
- How changes in global risk appetite contribute to higher credit spreads for banks worldwide

Broad credit deterioration, a weaker U.S. economy,and financial deleveraging have boosted potential losses...

Estimates of Potential Write-downs to Holders of U.S-Issued Securitized and Unsecuritized Debt

(March 08, $945 billions)

Source: IMF GFSR 2008

CDS for Banks and Investment Banks

Banks

(5-year CDS spreads in basis points)

Investment Banks

(5-year CDS spreads in basis points)

MKMV EDF Implied CDS Spreads (EICDS) and Market CDS Spreads for Groups of Banks

Banks without Subprime Exposure/Losses

Banks with Subprime Exposure/Losses

Banks with subprime exposure have higher spreads

Key Drivers of EDF and EICDS (EDF implied CDS)

EDF Key Drivers are Market Leverage and Asset Volatility

Key Drivers of credit spreads, EICDS, are (EDF, Market Sharpe Ratio (SR), correlation ρ of bank assets with market) and Loss Given Default

Trends in Banks’ Market Leverage and Asset Volatility

Banks with Subprime Exposure/Losses:

Market Leverage and Asset Volatility Both Increasing

Banks without Subprime Exposure/Losses:

Market Leverage Increasing but Asset Volatility Decreasing

This analysis was done by Andrea Maechler

Significantly Higher Market Sharpe Ratio since July 2007 to Peak in March 2008, still high Now

Market Sharpe Ratio and other indicators show decreased global risk appetite

Changes in Bank CDS due to Leverage, Volatility and Impact of Increase in Market Price of Risk as of March 20, 2008(Lower Risk Appetite, Higher Correlation)

Interbank spreads have widened since July 2007, in three different “spikes”

Application of CCA MKMV Model to Venzuelan Banks

- Default probailities, market leverage, and asset volatility for banking sector in Venzuela
- Comparison to USA and Europe
- Scenarios
- Lower global risk appetite
- Shock with lower equity, higer volatility

Venezuelan banks default probabilities (EDF, 1 yr) 2003-2008

Median for all banks; 75% Quartile; and 25% Quartile

Source: MKMV

Venezuelan banks asset volatility 2003-2008

Median for all banks; 75% Quartile; and 25% Quartile

Source: MKMV

Venezuelan banks market leverage (debt divided by assets) 2003-2008

Median for all banks; 75% Quartile; and 25% Quartile

Source: MKMV

Median EDF for Venezuelan Banks slightly higher than US banks which are slightly higher than EU banks

Highest one-fourth of banks in Venezuela and US have similar default probabilities (EDF), EU slightly lower

EDFs for Venezuelan Corporates (median, 75% quartile, and 25% quatile) slight increase since 2007

Spillovers to Emerging Markets (EM) Banks and Corporates

- EM banks’ spreads up somewhat, lower global risk appetite is a contributing factor
- Certain EM banks, dependent on foreign financing, under strain (e.g. Iceland)
- Sharp dropoff in EM corporate bond issuance
- EM corporate spreads up, global risk appetite is a factor
- Is the credit turmoil leading to reductions in credit to EM corporate and rise in borrowing cost that will have long term effects?

EM Corporate Bond Issuance Down and EM Corporate Spreads Up

EM Private Sector Bond Issuance

(In billions of U.S. dollars)

EM Corporate Spreads

(In basis points)

Rough Estimates of Drivers of Emerging Market (EM) Banks and (EM) Corporate Credit Spreads

Thank you, More information see:

- Papers by D. Gray, Robert C. Merton, Zvi Bodie:
- NBER 12637 (2006)
- NBER 13607 (2007)
- Sovereign Credit Risk, JOIM v. 5, no. 4, Dec 2007
- IMF Global Financial Stability Report (GFSR)
- IMF Working Papers: WP 05/155, 04/121, 07/233, Indonesia SIP (2006), Gray and Walsh (WP 08/89), Gray, Lim, Loukoianova, Malone (WP/08), IMF Staff Papers Gapen et. al v 55 #1 2008; Framework for Integrating Macroeconomics and Financial Sector Analysis by Gray, Karam, Malone, N’Diaye (forthcoming)
- Macrofinancial Risk Analysis, Gray and Malone (Wiley Finance book Foreword by Robert Merton)

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