Macrofinancial Risk: Fundamental Concepts and the Current International Context Dale Gray Monetary and Capital Markets Department International Monetary Fund The views expressed in this presentation are those of the author and should not be attributed to the International Monetary Fund, its Executive Board, or its management.

2 Macrofinancial Risk Analysis Framework integrates risk- adjusted balance sheets using Contingent Claims Analysis (CCA) with macroeconomic and monetary policy models CCA models of financial institutions, corporates, and sovereigns are integrated together and with macroeconomic models

3 Outline Contingent Claims Analysis (CCA) –CCA Models of Financial Institutions (Moody’sKMV) –Credit Turmoil and Financial Stability Risks Venezuelan Bank Sector Risk (MKMV) Global Spillovers to EM Corporates and Banks Based on papers by Dale Gray, Robert C. Merton and Zvi Bodie in: (i) JOIM 2007, (ii) NBER 2007; (iii) papers with Samuel Malone and new book on Macrofinance (2008); IMF GFSR 2008.

4 Core Concept: Merton Model/CCA for Firms and Banks Assets = Equity + Risky Debt = Equity + Default-Free Debt – Expected Loss = Implicit Call Option + Default-Free Debt – Implicit Put Option Assets Equity or Jr Claims Risky Debt Value of liabilities derived from value of assets. Liabilities have different seniority. Randomness in asset value.

5 CCA Credit Risk Measures Asset Value Exp. asset Distribution of Asset Value value path Distress Barrier or promised payments V 0 Time Probability of Default T Distance to Distress: standard deviations asset value is from debt distress barrier

6 Summary of CCA and Credit Risk Indicators Value of Risky Debt, D (A= asset, σ=asset volatility B=distress barrier, P=implicit put option) Default Probability Risk Neutral DP Estimated Actual DP

7 Calibrating Implied Assets and Asset Volatility Implied asset value and implied asset volatility calibrated from contingent claims analysis. Merton Model Moody’s-KMV for firms and financial institutions Merton-type CCA or hybrid models have been applied to corporates and financial institutions. Moody’sKMV, Kamakura and others have applied these models for credit risk analysis to tens of thousands of firms and banks in over 50 countries around the world. Sovereign CCA uses local currency liabilities and debt structure to imply sovereign assets and asset volatility, used to then get risk indicators such as spreads on foreign and local currency sovereign debt, default probabilities (MfRisk has been applied to 22 countries).

8 Calibrate (Unobservable) Market Value of Asset and Implied Asset Volatility INPUTS Value and Volatility of Market Capitalization, E Debt Distress Barrier B (from Book Value) Time Horizon USING TWO EQUATIONS WITH TWO UNKNOWNS Gives: Implied Asset Value A and Asset Volatility  A Default Probabilities Spreads, Risk Indicators KMV maps risk indicators to actual default probabilities (EDFs) using historical default data

9 Using CCA MKMV Models to Analyze the Global Crisis Overview of subrime and related losses Sharp increases in spreads of banks with and without subprime exposure Drivers of increased default probabilites for banks in US and Europe How changes in global risk appetite contribute to higher credit spreads for banks worldwide

10 Broad credit deterioration, a weaker U.S. economy, and financial deleveraging have boosted potential losses... Estimates of Potential Write-downs to Holders of U.S-Issued Securitized and Unsecuritized Debt (March 08, $945 billions) Source: IMF GFSR 2008

11 CDS for Banks and Investment Banks Banks (5-year CDS spreads in basis points) Investment Banks (5-year CDS spreads in basis points)

12 MKMV EDF Implied CDS Spreads (EICDS) and Market CDS Spreads for Groups of Banks Banks with Subprime Exposure/Losses Banks without Subprime Exposure/Losses Banks with subprime exposure have higher spreads

13 Key Drivers of EDF and EICDS (EDF implied CDS) EDF Key Drivers are Market Leverage and Asset Volatility Key Drivers of credit spreads, EICDS, are (EDF, Market Sharpe Ratio (SR), correlation ρ of bank assets with market) and Loss Given Default

14 Trends in Banks’ Market Leverage and Asset Volatility Banks with Subprime Exposure/Losses: Market Leverage and Asset Volatility Both Increasing Banks without Subprime Exposure/Losses: Market Leverage Increasing but Asset Volatility Decreasing This analysis was done by Andrea Maechler

15 Significantly Higher Market Sharpe Ratio since July 2007 to Peak in March 2008, still high Now Market Sharpe Ratio and other indicators show decreased global risk appetite

16 Changes in Bank CDS due to Leverage, Volatility and Impact of Increase in Market Price of Risk as of March 20, 2008 (Lower Risk Appetite, Higher Correlation) With Subprime Exposure/Loss Without Subprime Loss CDS January Increased Market Leverage Change in Volatility Market Price of Risk Increase (SR*ρ) CDS March bps145 bps

17 US Banks: Economic Capital Ratios with Low and High Market Price of Risk

18 Interbank spreads have widened since July 2007, in three different “spikes”

19 Application of CCA MKMV Model to Venzuelan Banks Default probailities, market leverage, and asset volatility for banking sector in Venzuela Comparison to USA and Europe Scenarios –Lower global risk appetite –Shock with lower equity, higer volatility

20 Venezuelan banks default probabilities (EDF, 1 yr) Median for all banks; 75% Quartile; and 25% Quartile Source: MKMV

21 Venezuelan banks asset volatility Median for all banks; 75% Quartile; and 25% Quartile Source: MKMV

22 Venezuelan banks market leverage (debt divided by assets) Median for all banks; 75% Quartile; and 25% Quartile Source: MKMV

23 Median EDF for Venezuelan Banks slightly higher than US banks which are slightly higher than EU banks

24 Highest one-fourth of banks in Venezuela and US have similar default probabilities (EDF), EU slightly lower

25 EDFs for Venezuelan Corporates (median, 75% quartile, and 25% quatile) slight increase since 2007

26 Spillovers to Emerging Markets (EM) Banks and Corporates EM banks’ spreads up somewhat, lower global risk appetite is a contributing factor Certain EM banks, dependent on foreign financing, under strain (e.g. Iceland) Sharp dropoff in EM corporate bond issuance EM corporate spreads up, global risk appetite is a factor Is the credit turmoil leading to reductions in credit to EM corporate and rise in borrowing cost that will have long term effects?

27 Emerging Market Bank External Bond Issuance is Down

28 EM Bank Spreads

29 EM Corporate Bond Issuance Down and EM Corporate Spreads Up EM Private Sector Bond Issuance (In billions of U.S. dollars) EM Corporate Spreads (In basis points)

30 Rough Estimates of Drivers of Emerging Market (EM) Banks and (EM) Corporate Credit Spreads EM BanksEM Corporates Credit Spreads January Increased Market Leverage ? Change in Volatility ? Mkt Price of Risk Increase* ? Credit Spreads January bps320 bps

31 Thank you, More information see: Papers by D. Gray, Robert C. Merton, Zvi Bodie: NBER (2006) NBER (2007) Sovereign Credit Risk, JOIM v. 5, no. 4, Dec 2007 IMF Global Financial Stability Report (GFSR) IMF Working Papers: WP 05/155, 04/121, 07/233, Indonesia SIP (2006), Gray and Walsh (WP 08/89), Gray, Lim, Loukoianova, Malone (WP/08), IMF Staff Papers Gapen et. al v 55 #1 2008; Framework for Integrating Macroeconomics and Financial Sector Analysis by Gray, Karam, Malone, N’Diaye (forthcoming) Macrofinancial Risk Analysis, Gray and Malone (Wiley Finance book Foreword by Robert Merton)