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Credit ratings in structured finance and the role of systemic risk

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  • Roberto Violi

    ()
    (Bank of Italy)

Abstract

This 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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File URL: http://www.bancaditalia.it/pubblicazioni/econo/temidi/td10/td774_10/en_td_774_10/en_tema_774.pdf
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Bibliographic Info

Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 774.

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Date of creation: Sep 2010
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Handle: RePEc:bdi:wptemi:td_774_10

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Keywords: structured finance; systemic risk; credit risk measures; bond pricing;

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  1. 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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