Forward-looking asset correlations in the estimation of economic capital

• Álvaro Chamizo ^[2] ; Alexandre Fonollosa ^[2] ; Alfonso Novales ^[1]
  1. [1] Universidad Complutense de Madrid

     Universidad Complutense de Madrid

     Madrid, España

     
  2. [2] BBVA
• Localización: Documentos de Trabajo (ICAE), ISSN-e 2341-2356, Nº. 25, 2019, págs. 1-48
• Idioma: inglés
• Enlaces
  • Texto completo (pdf)
• Resumen

  • Weanalyzewhetherthe creditmarket anticipatedthefinancial crisisbefore the regulatorsusinga 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- ivesincorporate forward-looking information on future systemic shocksthat 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 intersector correlations, although an appro- priately chosen second factor can provide additional information forrisk estimation in stressed times. We show that there were, indeed, signs of stressin the credit market that were not incorporated in the determination of economic capital during the crisis and thatsome financial institutions did not con- siderproperly. The overallimpressionisthatit is notso much thatrisk models were over-simplified to anticipate the financial crisis butrather, that they were backward-looking. A potential implication of our research is that the level of regulatory capitalshouldreacttoeventsinthe creditmarket.