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Credit Ratings in Structured Finance and the Role of Systemic Risk (Violi R.)

Financial Crises Ratings Risk-taking and Risk Management

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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Libref/ Violi R. (2010) "Credit Ratings in Structured Finance and the Role of Systemic Risk", Bank of Italy Temi di Discussione (Working Paper) No. 774, pp. 1 - 66
© Программирование — Александр Красильников, 2008
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