Thursday, August 16, 2007

System Risk (fg)

I found two interesting articles which contribute to recent financial market developments. Both papers stress the point of financal-innovation-induced systemic risk on the part of the finance sector.
Krahnen and Wilde 2006:
Large banks often sell part of their loan portfolio in the form of collateralized debt obligations(CDO) to investors. In this paper we raise the question whether credit asset securitization affects the cyclicality (or commonality) of bank equity values. The commonality of bank equity values reflects a major component of systemic risks in the banking market, caused by correlated defaults of loans in the banks’ loan books.The simulation results show that under plausible assumptions concerning bank reinvestment behaviour and capital structure choice, the issuing intermediary’s systematic risk tends to rise.
Chan et al.2005:

The hedge-fund industry has a symbiotic relationship with the banking sector, and many banks now operate proprietary trading units that are organized much like hedge funds. As a result, the risk exposures of the hedgefund industry may have a material impact on the banking sector, resulting in new sources of systemic risks. In this paper, we attempt to quantify the potential impact of hedge funds on systemic risk by developing a number of new risk measures for hedge funds and applying them to individual and aggregate hedge-fund returns data. These measures include: illiquidity risk exposure, nonlinear factor models for hedge-fund and banking-sector indexes, logistic regression analysis of hedge-fund liquidation probabilities, and aggregate measures of volatility and distress based on regime-switching models. Our preliminary findings suggest that the hedge-fund industry may be heading into a challenging period of lower expected returns, and that systemic risk is currently on the rise.