Forecasting Financial Risk Indicators

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Financial volatility is a crucial input for risk management, asset pricing and portfolio management and has important economic repercussions as evidenced in the recent financial crisis.  It is important to understand from a risk management standpoint the key drivers of volatility.

 

A recent working paper (March 2012) at the BIS, "A Comprehensive Look at Financial Volatility Prediction by Economic Variables", by Charlotte Christiansen, Malik Schmeling & Andreas Schrimpf looks at the use economic and financial variables as a predictor of volatility. Christiansen et al investigate if asset return volatility is predictable by macroeconomic and financial variables. The main goal of the study is to shed light on the economic sources of financial volatility. 

 

Their approach is distinct due to its comprehensiveness and extends recent research in several directions: First, they employ a long-term sample period and use forecast methodology to handle a large set of potential predictors, Second, they include multiple asset classes (equities, foreign exchange, bonds, and commodities), Third, they employ a comprehensive set of predictive variables which goes beyond existing studies in the literature on the economic drivers of volatility, and Fourth, the authors use comprehensive model selection and forecast combination procedures to assess whether economic variables are useful and robust predictors of financial volatility.  

 

The authors find that there is significant information contained in economic variables that helps in predicting future volatility for all four asset classes under study. Importantly, this predictive content by economic variables goes beyond the information contained in the history of the time series of realized volatility. 

 

The results are also supportive of financial volatility predictability by macroeconomic and financial variables in a realistic out-of-sample setting. The variables that are the most robust predictors of volatility are those that have sensible economic interpretations. In particular, variables that proxy for credit risk and funding liquidity (illiquidity) consistently show up significant forecast variable of volatility across several asset classes. Variables capturing time-varying risk premia (such as valuation ratios for equities, or interest rate differentials in foreign exchange) also perform well as significant indicators of volatility. 

 

In contrast to these financial predictors, variables that proxy for macroeconomic conditions, are much less informative about future volatility. Thus, the results suggest that channels that emphasize the effects of leverage, credit risk and funding illiquidity as well as time-variation of risk premia are the most promising candidates for understanding the economic drivers of financial volatility.

 

A key requirement for risk management is the understanding of volatility, but it also provides other information.  This may include uncovering linkages between price movements in financial markets and underlying risk factors or business cycle variables.  There is growing evidence showing that risks associated with volatility are priced into most asset and derivative markets. 

 

For more on this, follow the link:  www.bis.org/index.htm?ht=Research

 

 

The Cost of a Capital Cushion for Global Systemically Important Banks

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Recently, a number of financial institutions along with the International Institute of Finance (IIF), an industry association owned by financial institutions, have raised concerns about the economic costs for a capital cushion for global systemically important banks (GSIB).  The BIS has answered some of these questions in a recent report Assessment of the Macroeconomic Impact of Higher Loss Absorbency for Global Systemically Important Banks (BIS Macroeconomic Assessment Group, October 10^th).

Weakness in large financial institutions has often played a central role in the triggering and propagation of systemic financial crises.  The Financial Stability Board (FSB) and the Basel Committee on Banking have made a number of proposals for improving the loss absorbency of the GSIB and put together a Macroeconomic Assessment Group (MAG) to investigate the macroeconomic costs and benefits of these proposals. 

The GSIB proposal costs stem from the adverse impact on economic activity, bank policies to increase rate spreads and reduced lending to build up their capital buffers.  The 30 potential GSIBS, for the study, were based on their domestic market lending share and share of financial assets in their domestic economy.  

The initial result showed a 1% increase in the capital requirement reduced GDP by 0.06% over 8 years, or a little less than 0.01% per year.  The primary driver of this macroeconomic impact was the increase in lending spreads by 5-6 basis points.  The overall results conceal differences across countries related to role of the domestic financial system, existing capital buffers and international spillover effects.  It was found that by varying key assumptions: such as asset size, a larger bank list, a shorter implementation period or authorities altering only had a limited impact of growth. 

The MAG group looked at the full impact of implementation of all the Basel proposals and increased the capital buffer by an additional 2% for the GSIBs implemented over 8 years.  The actual results of the two components indicate reduced GDP growth by 0.04% per year while lending spreads rise by 31 basis points.  As noted earlier, different assumptions lead to different effects, while faster implementation or a weaker monetary response increasing the impact on GDP. 

The benefits for the GSIB framework relate primarily to the reduction in the exposure of the financial system to systemic crises that can have long-lasting effects on the economy and financial markets.

For more on this follow the link to the BIS:  http://www.bis.org/publ/bcbs202.htm

Central banking post-crisis: What compass for uncharted waters?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The global financial crisis has shaken the foundations of the deceptively comfortable pre-crisis banking world.  Central banks face a threefold challenge: economic, intellectual and institutional.  Claudio Borio in a paper for the Bank of International Settlements, notes the changing environment that central bankers face going forward; operating in a more hostile economic environment, the current economic benchmarks paradigms and models have failed and central banks will need to adjust their policy framework to maintain their independence. 

Policymakers will look for a new compass that should have the following characteristics: (1) tight interdependence between monetary and financial stability; (2) a greater awareness of the global, as opposed to purely domestic, dimensions of those tasks; and (3) the autonomy of central banks will need to be protected and strengthened. 

Borio notes three lessons that central banks learned from the crisis.  The first is that low and stable inflation does not guarantee financial and macroeconomic stability: monetary policy may have contributed to the crisis’s severity.  This is especially true during a period of prolonged easing.  The use of monetary policy to clean the post-crisis debris can be costly.  Interest-rate policy may not the right policy tool for the nature of the crisis: it is not optimal during a balance sheet recession.  There are times when a disagreement on policy may be as good as consensus.

Borio proposes the compass include adjustment to policy regimes, including the tighter integration of monetary policy and financial stability, adjustment for financial imbalances, consideration of monetary policy response to financial busts, the operational independence of central banks and a keener awareness of the global dimensions of these tasks.    

The key challenges for the implementation of the compass: the operational independence of central banks is likely to come under growing pressure and the need for greater international policy coordination.  A compass for central banks is needed as they sail into uncharted waters.

Please see the attached link for more details.  http://www.bis.org/publ/work353.htm