PrefBlog

The Bank for International Settlements has released its December 2009 Quarterly Review with:

• A review of current conditions
• Macro stress tests and crises: what can we learn?
• Monetary policy and the risk-taking channel
• Government size and macroeconomic stability
• Issues and developments in loan loss provisioning: the case of Asia
• Dollar appreciation in 2008: safe haven, carry trades, dollar shortage and overhedging

The review contained the following snippet of interest:

the market-implied price of credit risk also continued its downward trend, but to its pre-crisis level (Graph 11, left-hand panel).

The return to more normal credit market conditions was also reflected in corporate bond issuance (Graph 11, right-hand panel, and Highlights section).

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The methodology used to prepare the chart of market implied cost of risk has been summarized on PrefBlog.

The paper by Leonardo Gambacorta, Monetary policy and the risk-taking channel, has been highlighted by Bloomberg and makes the claim that ‘reaching for yield’ is not merely a retail problem:

This paper investigates the link between low interest rates and bank risk-taking. Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk. Using a comprehensive dataset of listed banks, this paper finds that low interest rates over an extended period cause an increase in banks’ risk-taking.

For instance:

The inertia in nominal targets at a time of lower interest rates may reflect a number of factors. Some are psychological, such as money illusion: investors may ignore the fact that nominal interest rates may decline to compensate for lower inflation. Others may reflect institutional or regulatory constraints.
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More generally, financial institutions regularly enter into long-term contracts committing them to produce relatively high nominal rates of return. The same mechanism could be in place whenever private investors use short-term returns as a way of judging manager competence and withdraw funds after poor performance

In the short term, low interest rates reduce the probability of default of outstanding variable rate loans, by reducing interest burdens of existing borrowers. In the medium term, however, due to the higher collateral values and the search for yield, banks tend to grant more risky loans and, in general, to soften their lending standards: they lend more to borrowers with bad credit histories and with more uncertain prospects. Overall, these results suggest that low interest rates reduce credit risk in banks’ portfolios in the short term – since the volume of outstanding loans is larger than the volume of new loans – but raise it in the medium term.

The empirical exercise points to a number of other interesting findings. First, developments in housing prices prior to the crisis appear to have contributed to bank risk-taking. An inflation-adjusted house price growth rate that is 1 percentage point above its long-run average for six consecutive years leading up to the crisis increases the probability of default of the average bank by 1.5%. This result is in line with the view that the housing market had a substantial role in the crisis and that banking distress was typically more severe in countries that experienced a more pronounced boom-bust cycle in house prices.

Second, banks that experienced a higher growth rate of lending with respect to the industry average prior to the crisis proved to be riskier ex post. For example, lending of about 10% above average over the six years preceding the crisis caused an increase in bank probability of default by 3.9%.

Jeffery D Amato wrote a paper with the captioned title in the BIS Quarterly Review, 4Q05:

Credit default swap (CDS) spreads compensate investors for expected loss, but they also contain risk premia because of investors’ aversion to default risk. We estimate CDS risk premia and default risk aversion to have been highly volatile during 2002–2005. Both measures appear to be related to fundamental macroeconomic factors, such as the stance of monetary policy, and technical market factors, such as issuance of collateralised debt obligations.
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To proxy for default probabilities, we use one-year EDFs™ as in the study by Berndt et al (2005). EDFs™ are constructed using balance sheet and equity price data under the principles of a Merton-type model for gauging the likelihood of default. Our data on EDFs™ are available at a monthly frequency for all but two firms in the CDX.NA.IG.4 index. Aggregate and sector EDFs™ are constructed as simple arithmetic averages of existing data on the constituents.
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In order to see how we obtain measures of risk premia and risk aversion, note that CDS spreads can be roughly decomposed as follows:

CDS spread = expected loss + risk premium
= expected loss x risk adjustment

where

risk adjustment = 1 + price of default risk

The first equation above says that the CDS spread is approximately equal to expected loss plus a risk premium, where the latter is compensation paid to investors for enduring exposure to default risk. In the second equation, the spread is re-expressed in terms of risk-adjusted expected loss, where the risk adjustment varies proportionally with the price of default risk. The price of default risk has the interpretation as the compensation per unit of expected loss. It is an indicator of investors’ aversion to default risk: a positive price of risk means that investors demand that they be paid more than actuarial losses. Hereafter, we will use the terms “price of default risk” and “indicator of default risk aversion” interchangeably.

While the formulations of spreads above isolate a “risk premium” and a “price of risk”, in principle there are two distinct types of default risk that may command a premium. One is cyclical variation in expected loss, which usually rises during economic downturns, when overall income growth is low. The other is the actual default of an entity and its impact on investors’ wealth due to an inability to perfectly diversify credit portfolios. In the literature, these are generally referred to as systematic and jump-at-default risk, respectively.

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The use of Moody’s KMV methodology to determine intrinsic default probability is similar to the Bank of England approach, but different from the recently published Bank of Canada liquidity research which, essentially, assigns a value of zero to the variable “price of default risk”.