Credit ratings in structured finance and the role of systemic risk
AbstractThis paper explores the implications of systemic risk in Credit Structured Finance (CSF). Risk measurement issues loomed large during the 2007-08 financial crisis, as the massive, unprecedented number of downgrades of AAA senior bond tranches inflicted severe losses on banks, calling into question the credibility of Rating Agencies. I discuss the limits of the standard risk frameworks in CSF (Gaussian, Single Risk Factor Model; GSRFM), popular among market participants. If implemented in a ‘static’ fashion, GSRFM can substantially underprice risk at times of stress. I introduce a simple ‘dynamic’ version of GSRFM that captures the impact of large systemic shocks (e.g. financial meltdown) for the value of CSF bonds (ABS, CDO, CLO, etc.). I argue that a proper 'dynamic' modeling of systemic risk is crucial for gauging the exposure to default contagion (‘correlation risk’). Two policy implications are drawn from a 'dynamic' GSRFM: (i) when rating CSF deals, Agencies should disclose additional risk information (e.g. the expected losses under stressed scenarios; asset correlation estimates); and (ii) a ‘point-in-time’ approach to rating CSF bonds is more appropriate than a ‘through-the-cycle’ approach.
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Bibliographic InfoPaper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 774.
Date of creation: Sep 2010
Date of revision:
structured finance; systemic risk; credit risk measures; bond pricing;
Find related papers by JEL classification:
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- E65 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Studies of Particular Policy Episodes
- G01 - Financial Economics - - General - - - Financial Crises
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
- G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
- G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-10-23 (All new papers)
- NEP-BAN-2010-10-23 (Banking)
- NEP-FMK-2010-10-23 (Financial Markets)
- NEP-RMG-2010-10-23 (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.:
- Ingo Fender & John Kiff, 2004. "CDO rating methodology: Some thoughts on model risk and its implications," BIS Working Papers 163, Bank for International Settlements.
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