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Forward-looking asset correlations in the estimation of economic capital



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Chamizo Cana, Álvaro and Fonollosa, Alexandre and Novales Cinca, Alfonso Forward-looking asset correlations in the estimation of economic capital. [ Documentos de Trabajo del Instituto Complutense de Análisis Económico (ICAE); nº 25, 2019, ISSN: 2341-2356 ]

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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.

Item Type:Working Paper or Technical Report
Additional Information:

5The authors acknowledge comments received from C. Matres Santos.
Preprint submitted to Elsevier, 9th April 2019

Uncontrolled Keywords:Forward-looking Asset Correlation; Economic Capital; Asset Allocation; Systemic Risk.
Subjects:Social sciences > Economics > Econometrics
Social sciences > Economics > Finance
JEL:E47, G01, G28, G32
Series Name:Documentos de Trabajo del Instituto Complutense de Análisis Económico (ICAE)
ID Code:57131
Deposited On:27 Sep 2019 11:12
Last Modified:17 Oct 2019 12:07

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