Systemic bank risk in Brazil: an assessment of correlated market, credit, sovereign and inter-bank risk in an environment with stochastic volatilities and correlations

In this study we develop and demonstrate a powerful and flexible forward-looking portfolio simulation methodology for assessing the correlated impacts of market risk, and private sector, sovereign and inter-bank default risk on both individual banks (i.e. 28 of the largest Brazilian banks) and groups of banks (i.e. the Brazilian banking system). The methodology importantly accounts for bank asset and liability maturity and currency mismatches and loan portfolio credit quality and sector and region concentrations. In a significant innovation, financial and economic environment variables are modeled with stochastic volatilities and correlations. We demonstrate the reliability of the models by comparing simulated and historical credit transition probabilities, simulated and historical bank rates of return, and simulated versus actual bank credit ratings. When omitting sovereign risk our analysis indicates that none of the banks face significant default risk over a 1-year horizon. This low default risk stems primarily from the large amount of government securities held by Brazilian banks, but also reflects the banks' adequate capitalizations and extraordinarily high interest rate spreads. Once sovereign risk is considered and losses in the market value of government securities reaches 10 percent (or higher), several banks face potential solvency problems. These results demonstrate the well known risk of concentrated lending to a borrower which has a non-zero probability of default (e.g. Government of Brazil). We also demonstrate the potential systemic risk impact of variation in average recovery rates on defaulted private sector loans which reflect, among other factors, bank lending policies, the efficiency of the legal system in resolving defaults, and aggregate levels of defaults. Our analysis also highlights the importance of accounting for the differential risk characteristics of various banks and for the inter-bank risk channel, through which a systemic crisis may propagate. It further indicates that, in the event of a sovereign default, the Government of Brazil would face constrained debt management alternatives. To the best of our knowledge no one else has put forward a systematic methodology for assessing correlated market and credit (sovereign, corporate and inter-bank) default risk for a financial system.