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Forward-looking asset correlations in the estimation of economic capital

Álvaro Chamizo, Alexandre Fonollosa and Alfonso Novales

Journal of International Financial Markets, Institutions and Money, 2019, vol. 61, issue C, 264-288

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 derivatives 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 appropriately 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 consider 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.

Keywords: Forward-looking asset correlation; Economic capital; Financial crisis; Asset allocation; Systemic risk (search for similar items in EconPapers)
JEL-codes: E47 G01 G28 G32 (search for similar items in EconPapers)
Date: 2019
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