Market- and Book-Based Models of Probability of Default for Developing Macroprudential Policy Tools
AbstractThe recent financial crisis raised awareness of the need for a framework for conducting macroprudential policy. Identifying as early as possible and addressing the buildup of endogenous imbalances, exogenous shocks, and contagion from financial markets, market infrastructures, and financial institutions are key elements of a sound macroprudential framework. This paper contributes to this literature by estimating several models of default probability, two of which relax two key assumptions of the Merton model: the assumption of constant asset volatility and the assumption of a single debt maturity. The study uses market and banks? balance sheet data. It finds that systemic risk in Luxembourg banks, while mildly correlated with that of European banking groups, did not increase as dramatically as it did for the European banking groups during the heights of the financial crisis. In addition, it finds that systemic risk has declined during the second half of 2010, both for the banking groups as well as for the Luxembourg banks. Finally, this study illustrates how models of default probability can be used for event-study purposes, for simulation exercises, and for ranking default probabilities during a period of distress according to banks? business lines. As such, this study is a stepping stone toward developing an operational framework to produce quantitative judgments on systemic risk and financial stability in Luxembourg.
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Bibliographic InfoPaper provided by Central Bank of Luxembourg in its series BCL working papers with number 65.
Length: 38 pages
Date of creation: Oct 2011
Date of revision:
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Web page: http://www.bcl.lu/
financial stability; credit risk; structured products; default probability; GARCH;
Find related papers by JEL classification:
- C30 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - General
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- G1 - Financial Economics - - General Financial Markets
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-11-07 (All new papers)
- NEP-BAN-2011-11-07 (Banking)
- NEP-CBA-2011-11-07 (Central Banking)
- NEP-RMG-2011-11-07 (Risk Management)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Thorsten Lehnert & Xisong Jin & Francisco Nadal de Simone, 2011. "Does the GARCH Structural Credit Risk Model Make a Difference?," LSF Research Working Paper Series, Luxembourg School of Finance, University of Luxembourg 11-6, Luxembourg School of Finance, University of Luxembourg.
- Geske, Robert, 1977. "The Valuation of Corporate Liabilities as Compound Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 12(04), pages 541-552, November.
- Marcos Souto & Benjamin M. Tabak & Francisco Vazquez, 2009. "Linking Financial and Macroeconomic Factors to Credit Risk Indicators of Brazilian Banks," Working Papers Series, Central Bank of Brazil, Research Department 189, Central Bank of Brazil, Research Department.
- Gaston Giordana & Ingmar Schumacher, 2012. "An Empirical Study on the Impact of Basel III Standards on Banks? Default Risk: The Case of Luxembourg," BCL working papers, Central Bank of Luxembourg 79, Central Bank of Luxembourg.
- Xisong Jin & Francisco Nadal De Simone, 2012. "An Early-warning and Dynamic Forecasting Framework of Default Probabilities for the Macroprudential Policy Indicators Arsenal," BCL working papers, Central Bank of Luxembourg 75, Central Bank of Luxembourg.
- Xisong Jin & Francisco Nadal De Simone, 2013. "Banking Systemic Vulnerabilities: A Tail-risk Dynamic CIMDO Approach," BCL working papers, Central Bank of Luxembourg 82, Central Bank of Luxembourg.
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