William Perraudin

• Risk Control Limited

Regulatory authorities in Europe may wish to reconsider the capital that banks and insurers hold against their securitisation exposures. Such a review is justified by the need for Europe to finance climate and digital transitions. Boosting investment will only be possible if the continent's banks can create lending headroom through securitisation....

European policymakers have argued that Europe needs “massive private investments” to advance the climate agenda and generate higher productivity and competitiveness. While equity markets can provide EU corporates with some risk capacity to invest more, it will be for debt markets to finance the bulk of the needed investment. European banks, as key...

European policymakers have argued that Europe needs "massive private investments" (see ECB (2024a)) to advance the climate agenda and generate higher productivity and competitiveness. While equity markets can provide EU corporates with some risk capacity to invest more, it will be for debt markets to finance the bulk of the needed investment. Europ...

Financial regulation within Advanced Economies (AEs) is a key driver of capital flows to Emerging Market and Developing Economies (EMDEs). Bank capital rules affect the ability of developed country banks to lend and invest in EMDE financial instruments. Trading book capital rules influence whether banks can deal in Emerging Market (EM) cash and der...

Recent studies have advanced widely differing views on the state of liquidity in the European corporate bond market. This report aims to provide comprehensive empirical evidence on how liquidity in this market has evolved. We show that turnover ratios and mean trade numbers have declined. We also show that an increasing number of bonds are hardly...

To discourage the "originate-to-distribute" business model (which created the US subprime mortgage securitisation industry and caused the recent financial crisis) policymakers require that originators retain sufficient risk to have so-called "skin-in-the-game". In defining retention rules, European policymakers settled on the wording of "not less t...

The European Commission has issued proposals for reviving the European securitisation market by moderating the stringency of prospective Basel rules for qualifying Simple, Transparent and Standardised (STS) securitisations. This paper sets out the background to these proposals, analyses impediments to their success and suggests remedies. The key i...

The Basel Committee has recently announced plans to revise the Standardised Approach (SA) to bank capital for credit risk and to employ the revised SA as a floor for bank capital based on internal models. Some aspects of the proposals remain unclear but it is likely that the new approaches will have a major impact on the overall level of capital an...

European SMEs have been among the primary casualties of the credit crunch that has gripped much of Europe since the crisis of 2007-8 and the subsequent European sovereign debt crisis of 2011-12. Banks’ attempts to rebuild their balance sheets and meet stringent new capital requirements have led them to scale back their lending. Liquidity requiremen...

Bank counter-party risk became a major issue for many market participants during the recent financial crisis. The risk was complex and involved multiple dimensions. Fluctuations in risk occurred not just as the financial state of banks fluctuated but also because the capacity and willingness of sovereigns to rescue banks changed over time. Major c...

Risk Control thanks the European Commission for the opportunity to address the issues raised in the Consultation Document on an EU framework for simple, transparent and standardised securitisation published on 18th February 2015 (the “Consultation”). Securitisation provides an important source of funding for bank and non-bank lenders. This is part...

This paper develops a simple but rigorous approach to allowing for default probability risk in securitisation capital calculations. The approach consists of including additional random factors to describe risk in inputs, specifically default probabilities for pool loans. We show that the addition of such “parameter risk” translates into more conser...

This document provides comments on BCBS 307 which describes the Basel Committee’s proposals for a revised credit risk Standardised Approach (SA). Under the revised SA, the risk weights for exposures to banks, corporates and commercial and residential mortgages depend on risk indicators. Agency ratings which, when available, are the basis for corpor...

An interesting recent article in the BIS Quarterly Bulletin by Antoniades and Tarashev argues that capital for mezzanine tranches of securitisations should be boosted substantially because of uncertainty about pool default probabilities. The authors claim that this is true even when the securitisations are Simple, Standard and Transparent (SST) in...

This note presents an illustrative case study of stress testing for an asset manager accomplished using Risk Control’s Stress ControllerTM software. The calculations are performed for a notional UK asset manager that is also engaged in private banking operations. We show how the AUM (Assets Under Management), balance sheet, P&L and key capital pla...

This document sets out Risk Control’s response to the BCBS-IOSCO consultative document entitled “Criteria for identifying simple, transparent and comparable securitisations”. We welcome the work of the BCBS-IOSCO taskforce on this topic which we regard as an important part of formulating an appropriate regulatory framework for the securitisation m...

"European policy-makers view the revival of the securitisation market as a key step in (i) restoring orderly funding to European banks and (ii) boosting lending necessary for growth. Current and proposed regulatory capital rules are, however, major impediments to reviving the securitisation market. Since the crisis, changes in ratings agencies meth...

European policy-makers view the revival of the securitisation market as a key step in (i) restoring orderly funding to European banks and (ii) boosting lending necessary for growth. Current and proposed regulatory capital rules are, however, major impediments to reviving the securitisation market. Since the crisis, changes in ratings agencies metho...

The ECB will soon adopt a set of eligibility criteria for its planned ABS purchase programme. These criteria are likely to include a restriction based on agency ratings. The inclusion of dependence on agency ratings in yet another area of official or regulatory policy is regrettable and is inconsistent with the frequently expressed intention of Eur...

This note presents comparisons of risk weights calculated using three approaches proposed in the recent Basel consultative paper on securitisation capital, BCBS 269. These approaches are the Internal Ratings Based Approach (IRBA), the External Ratings Based Approach (ERBA) and the Standardised Approach (SA). The data we employ is supplied by a gro...

The risk and liquidity characteristics of securitisations vary greatly, posing challenges for investors and regulators alike. Recently, there has been interest in the possibility of identifying, through simple observable characteristics, a category of High Quality Securitisation (HQS) likely to exhibit lower risk and higher liquidity. Such securiti...

This note presents a stress testing case study for a set of banks with inter-bank obligations, illustrating how stress testing may be accomplished using Risk Control’s Stress ControllerTM software. The calculations are performed for a banking sector comprising three individual banks (labelled A, B and C). The software may accommodate any number of...

This paper presents a calibration of the Conservative Monotone Approach (CMA), a model of capital for securitisation tranches, and shows how it may be used as the basis for regulatory capital. The CMA is risk-sensitive and implementable by both investor and originator banks. We explain how regulatory judgement may be exercised in the calibration so...

The Simplified Supervisory Formula Approach (SSFA) is a simple, ad hoc approach to allocating capital across tranches with different seniorities. The SSFA has been adopted by the Basel authorities in their latest proposal (December 2013) as their formula-based approach for securitisation regulatory capital with a given calibration. In this paper,...

This paper describes the disadvantages of using agency ratings for securitisations in regulatory applications, and in particular as a basis for regulatory capital. We argue that an external ratings based approach to securitisation capital has become close to unworkable since the crisis, particularly in Europe because of major practical problems cre...

The EBA has analysed the liquidity of different asset classes as part of its work for the European Commission on definitions to be employed in a European implementation of the Liquidity Coverage Ratio. This paper critically examines the EBA’s analysis, focussing on the exclusion of bid-ask spread data from the evidence employed. Using bid-ask sprea...

This paper examines the effects of granularity and heterogeneity on capital requirements for securitisation transactions. For securitisation portfolios exhibiting a low number of obligors, a granularity adjustment to the Arbitrage Free Approach (AFA) (proposed by Duponcheele et al (2013a)) is derived in detail. The adjustment is based on a second-o...

This paper examines how the capital required for securitisation tranche exposures varies as the maturity of the securitisation increases. We investigate for different maturities the appropriate capital for (i) loan pools, (ii) securitisation deals as a whole (i.e., all the tranches within a given deal), and (iii) individual tranches of differing se...

This paper proposes a variant of the Arbitrage Free Approach (AFA) (developed by Duponcheele et al. (2013)) applicable when the available inputs are risk weights alone. This Simplified AFA, together with the AFA itself, offer a consistent set of approaches for regulatory capital calculations that can be used by investor or issuer banks without rely...

This paper develops a principles-based approach to calculating regulatory capital for securitisations. The approach is simpler and more transparent than the Basel Committee’s proposed Modified Supervisory Formula Approach (MSFA) and avoids the latter’s numerous opaque approximations. Importantly, our proposed approach is directly consistent with th...

This note shows through a case study how Risk Control’s Stress Controller software may be used to implement top down stress testing of a bank. The calculations are based on the publicly available financial statement and Pillar 3 disclosures of a large UK bank. We show how the balance sheet, P&L and key financial ratios are affected by scenarios in...

This paper investigates the relation between credit and market risk over long investment horizons. We split credit risk into transition and spread risk so that results can be directly related to ratings-based credit risk models which adopt this decomposition. We nd that spread risk for high credit quality exposures exhibits variable but generally n...

Knowing the relative riskiness of different types of credit exposure is important for policy-makers designing regulatory capital requirements and for firms allocating economic capital. This paper analyses the risk structure of credit exposures with different maturities and credit qualities. It focuses particularly on risks associated with (i) ratin...

This article describes the Basel II capital rules for securitization exposures, explaining the considerations that influenced regulators' decisions, the approaches for calculating capital and how banks will apply them, the financial engineering that underlies the different approaches and the likely impact of the new system.

This lecture describes incomplete information timing games. We suppose that agents have interdependent payo s and there is an advantage to going early so the structure is one a preemption game. 1 A Preemption Game with Incomplete Information 1.1 Basic Assumptions The strategic models of stopping developed by Smets (1993) implies that value is lost...

Numerous studies have examined the effect on credit spreads of renegotiation. These studies have generally focused on the impact on spread levels in general, and not on how renegotiation influences the relative pricing of senior versus junior debt claims. In this paper, we show that the scope for sequential renegotiation may reduce and even elimina...

This paper formulates a simulation model of a bank balance sheet and analyses optimal choices of portfolio credit quality and funding maturity under different assumptions about liquid assets requirements that may be imposed by regulators. We employ industry standard approaches to modelling portfolio payoffs. Funding costs are assumed to rise if imp...

We model aggregate loss rates on credit portfolios dynamically using a default intensity approach. The default intensity we employ is allowed to depend on both observable macroeconomic variables and unobserved frailties. We use the model to extract measures of the credit cycle from US bank charge-off rates and find that unemployment, industrial pro...

This paper applies a new class of dynamic credit loss rate models to the pricing of benchmark synthetic Collateralized Debt Obligations (CDOs). Our approach builds directly on the static, industry-standard, pricing approach to credit structured products based on Vasicek (1991). We generalize the Vasicek model by allowing risk factors to be driven b...

This paper investigates factors that contribute to the cross-sectional pattern of spreads in Asset-Backed Security (ABS) prices in times of crisis. The periods include the crisis in the Manufactured Housing sector in 2004 and the turmoil in mortgage backed ABS in 2007. The cross section of prices for a given rating category appear to be poorly expl...

Banks have recently developed new techniques for gauging the credit risk associated with portfolios of illiquid, defaultable instruments. These techniques could revolutionise banks' management of credit risk and could in the longer term serve as a more risk-sensitive basis for calculating regulatory capital on banks' loan books than in Basel 2, the...

This paper generalizes a class of ratings-based credit derivative models proposed by Jarrow, Lando, and Turnbull (1997) and Kijima and Komoribayashi (1998) to allow for stochastic spreads and then applies this model to analyze empirically the pricing of large cross sections of corporate bonds and Asset Backed Securities. We show that measuring risk...

In standard ratings-based models for analyzing credit portfolios and pricing credit derivatives, it is assumed that defaults and recoveries are statistically independent. This paper presents evidence that aggregate quarterly default rates and recovery rates are, in fact, negatively correlated. Using Extreme Value Theory techniques, we show that the...

This paper presents techniques for hedging structured products in incomplete markets. Under actual distributions, we simulate correlated ratings histories for pool exposures up to the hedging horizon and then employ conditional pricing functions estimated from a preliminary Monte Carlo based on risk adjusted distributions. The approach is very flex...

This paper compares the risk of structured exposures with that of defaultable corporate bonds with the same agency ratings. Risk is defined in a variety of ways including return volatility, value at risk, expected shortfall and betas with credit portfolios.

Recent research by Elton et al (2001) argues that investment-quality defaultable debt spreads reflect three factors: expected losses, risk premiums and taxes. In this paper, we sort bond price data on liquidity proxies (quote frequency, bond age and issue size) and show that an important additional component of spreads is a liquidity premium.

We study the consistency of the credit-risk orderings implicit in ratings and bond market yields. By analyzing errors in term structure estimates for bonds with particular ratings, we show that for significant periods, a quarter of some categories of high credit quality bonds are rated in a manner that is inconsistent with their pricing. Adjusting...

This paper introduces incomplete information and preemption into an equilibrium model of firms facing real investment decisions. The optimal investment strategy may lie anywhere between the zero-NPV trigger level and the optimal strategy of a monopolist, depending on the distribution of competitors’ costs and the implied fear of preemption. Our mod...

We study the extent to which crashes in emerging market currencies are predictable using simple logit models based on lagged macroeconomic and financial data. To evaluate our model, we calculate trading strategies in which an investor goes long or short in the currency depending on whether crash probabilities are low or high. When we estimate the m...

Recent studies by Ambrose, Buttimer, and Capone have stressed the fact that lender and borrower decisions after the initial default on a mortgage may significantly affect the amount and timing of recoveries and hence, more broadly, the value and riskiness of mortgage loan portfolios. This study uses microeconomic data from the UK to examine the tim...

This paper examines the practical usefulness of Extreme Value Theory (EVT) techniques for estimating Value-at-Risk (VaR). Unlike most past studies, the performance of EVT estimators of empirical return distributions. We show that for confidence levels similar to those commonly used in market risk calculations, EVT and naive estimators yield almost...

One of the most important policy issues for financial authorities is to decide at what level average capital charges should be set. The decision may alternatively be expressed as the choice of an appropriate survival probability for representative banks over a horizon such as a year, often termed a “solvency standard”. This article sheds light on t...

This paper compares the informational content of judgmentally determined sovereign ratings produced by a private sector bank and by the rating agency Standard and Poor's, with ratings derived from econometric analysis of sovereign default. We show that downgrades in both the bank and the agency ratings may be predicted using quantitative ratings wh...

Rating transition matrices for sovereigns are an important input to risk management of portfolios of emerging market credit exposures. They are widely used both in credit portfolio management and to calculate future loss distributions for pricing purposes. However, few sovereigns and almost no low credit quality sovereigns have ratings histories lo...

The recent interest in portfolio credit risk modelling has concentrated attention on the correlation structure of credit risk. This paper calculates long-holding period correlations for emerging market sovereign spreads and compares these with the correlations of equity market indices for the same countries.

This paper shows how default hazards similar to those suggested by the literature on reduced form credit risk models may arise purely from the strategic behavior of indebted firms operating in a duopoly. In so doing, our research advances attempts to reconcile structural and reduced form approaches to modelling credit risk. In equilibrium, firm def...

Recent research has highlighted the role that the government budget constraint plays in determining the consumer price level. According to the fiscal approach to price determination, prices adjust so that the discounted value of future real government primary surpluses equals the current real value of public debt. An important implication is that t...

This paper argues that the `fiscal theory or the price level' (FTPL), developed by Woodford, Cochrane, Sims and others, is a fallacy. The source of the fallacy is an elementary economic misspecification. The FTPL denies a fundamental property of any model of a market economy, that the budget constraint of any agent, private or public, must be satis...

The distribution of ratings changes plays a crucial role in many credit risk models. As is well-known, these distributions vary across time and different issuer types. Ignoring such dependencies may lead to inaccurate assessments of credit risk. In this paper, we quantify the dependence of rating transition probabilities on the industry and domicil...

We estimate a microeconomic model of household asset demands that allows for the fact that households typically have zero holdings of most assets. The adjustments for non-observed heterogeneity generalize methods developed by Dubin and McFadden (1984. Econometrica 52, 345–362). Simulating our model using a random sample of US households, we examine...

Bargaining over the terms of multilateral lending can be a prolonged process. We model failure to come to quick agreement as a screening device. Policy makers who find conditionality especially costly delay to signal their type. We show that increased costs to not reaching agreement, whether borne by borrowers or lenders, can increase the chances o...

This introduction places in context the papers on credit risk modelling contained in the special issue. We explain why credit risk modelling has become such a focus of interest for practitioners and financial supervisors. Even though, as we explain, the current modelling technologies have significant weaknesses, they offer the possibility of major...

The problem of estimating volatility is one of the most important topics in modern finance. Accurate specification of volatility is a prerequisite for modelling financial time series, such as interest rates or stocks, and crucially affects the pricing of contingent claims. Modelling volatility has therefore be widely discussed in the financial lite...

Value at risk (VaR) techniques are difficult to apply when portfolios have significant exposures to non-linear derivative claims such as options. This article analyzes the biases introduced by standard delta and delta-gamma VaR methods for options. These methods employ local approximations and adopt very strong assumptions about the Gaussianity of...

Corporate restructurings involving a redeployment of assets into other activities provide an important way in which rms alleviate nancial distress. This paper examines the degree to which loan sales and credit derivatives markets assist or hinder restructurings. We show that loan sales lead to a postponement of restructuring. Furthermore, they may...

Many Latin American countries appear locked into cycles of reserve loss, devaluation and temporary reserve gains. This paper shows how a dual exchange rate system with leakages may generate cycles in reserves and the premium between official and parallel exchange rates. We study the dynamics of these cycles and their asymptotic behavior both analyt...

The author offers insight into the four papers presented.

Securities fraud It is a matter of incentives from bottom to top Recent frauds in investment banks and securities houses have revealed how vulnerable modern financial institutions are to criminal activity by their employees. In this paper, we examine how regulators may limit the incidence of securities fraud by encouraging firms to provide managers...

This paper was presented at the conference "Financial services at the crossroads: capital regulation in the twenty-first century" as part of session 1, "Impact of capital requirements on bank risk taking: empirical evidence." The conference, held at the Federal Reserve Bank of New York on February 26-27, 1998, was designed to encourage a consensus...

The aim of this article is 2-fold: first to test the adequacy of Pareto distributions to describe the tail of financial returns in emerging and developed markets, and second to study the possible correlation between stock market indices observed returns and return's extreme distributional characteristics measured by Value at Risk and Expected Short...

This paper employs duration analysis to investigate the timing of default in the UK mortgage market. Our analysis is performed on an ex ante basis, in that our explanatory variables are available to mortgage lenders when the loan is first made. We estimate both standard Weibull distributions and generalizations of the Weibull that permit non-monoto...

Approximating the Finite Sample Bias for Maximum Likelihood Estimators Using the Score–Solution - Volume 13 Issue 2 - Bert Lambrecht, William Perraudin, Stephen Satchell

To measure the risks involved in their trading operations, major banks are increasingly employing value at risk (BR) models. In an important regulatory innovation, the Basle Committee has proposed that such models be used in the determination of the capital that banks must hold to back their securities trading. This article examines the empirical p...

This paper considers the empirical assessment of the relationship between prices and number of firms in local markets in geographic or, more generally, characteristic space and its use as evidence in merger cases. It outlines a structural, semi-nonparametric econometric model of competition in such markets, examines its testable implications in ter...

When firms experience financial distress, equity holders may act strategically, forcing concessions from debtholders and paying less than the originally contracted interest payments. This article incorporates strategic debt service in a standard, continuous time asset pricing model, developing simple closed-form expressions for debt and equity valu...

Pension systems in different countries vary widely in such aspects as the dependence of benefits on earlier labour income, the minimum permitted retirement age and limits on labour supply after retirement. This paper uses a simulation model of a rational, utility-maximising household facing the detailed pension provisions of eight European countrie...

This article shows (1) how entry and exit of firms in a competitive industry affect the valuation of securities and optimal capital structure, and (2) how, given a trade-off between tax advantages and agency costs, a firm will optimally adjust its leverage level after it is set up. We derive simple pricing expressions for corporate debt in which th...

The way in which countries conduct monetary policy significantly affects the distribution of their short interest rates and hence the pricing of bonds further along the yield curve. This chapter examines the impact of monetary policy on the higher moments and persistence of interest rate changes. We present a simple version of an analytic model of...

Recent research has begun the task of integrating contingent claims analysis with modern corporate finance by incorporating strategic behaviour in dynamic models of corporate security valuation. This paper reports on and illustrates these developments by presenting a simple pricing model in which two debt-holders with incomplete information about e...

Demographic and fiscal pressures make pension reform in Europe an important issue. The need for reform represents an opportunity for countries to reconsider the design of their pension systems and reduce the distortions they induce in labour and savings markets. This paper examines the economic effects of public pension systems in the four largest...

The authors formulate and test a continuous time asset pricing model using U.S. equity market data. They assume that stock returns are driven by common factors including random jump-size Poisson processes and Brownian motions with stochastic volatility. The model places over-identifying restrictions on the mean returns allowing one to identify risk...

The economic effects of an ageing population are preoccupying policy-makers in most industrial countries. In this paper, we study the economic impact of the demographic shock in Finland, a country for which the post-war fertility shock was particularly large. The framework for our analysis is an overlapping generations simulation model parametrised...

University of Cambridge/DAE, n° 9416