Price of Risk: Recent Evidence From Large Financials

Abstract

Probability of default (PD) measures have been widely used in estimating potential losses of, and contagion among, large financial institutions. In a period of financial stress however, the existing methods to compute PDs and generate loss estimates may vary significantly. This paper discusses three issues that should be taken into account in using PD-based methodologies for loss or contagion analyses: (i) the use of "risk-neutral probabilities" vs. "real-world probabilities;" (ii) the divergence between movements in credit and equity markets during periods of financial stress; and (iii) the assumption of stochastic vs. fixed recovery for financial institutions' assets. All three elements have nontrivial implications for providing an accurate estimate of default probabilities and associated losses as inputs for setting policies related to large banks in distress. This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Reforming Financial Executives’ Compensation for the Long Term

“…administrative process. Proposals that advocate pegging compensation to a specifi c debt security, such as credit-default swaps or subordinated debt, rather than a proportionate package of the capital structure, while seemingly avoiding complexity, do not satisfactorily avoid the problem, as those securities are also typically not publicly traded, 41 and it appears that, particularly in times of crisis, credit-default swap spreads understate the risk of loss, with volatility manifested in equity prices instead (Singh and Youssef 2010). 42 Finally, determining the appropriate formula with which to relate changes in default spreads to executive compensation bonuses or claw-backs would undoubtedly be a challenging task, for the calculation of swap prices is complex, as values do not change linearly with changes in other economic variables.…”

“…An explanation for the understated spreads is that bondholders viewed the institutions as too big to fail, and therefore did not expect to bear losses (Milne 2010). Singh and Youssef (2010) suggest alternative complicated methodologies to better price risk than straightforward use of credit default swap spreads. The convertible security that Gordon (2010) proposes has further valuation diffi culties: because management's stock diff ers signifi cantly from that of other stockholders (i.e., management's shares will become debt securities, which are senior to the outstanding shares of stockholders, when the fi rm experiences fi nancial diffi culty), their stock will not be equivalent in value, nor will its value move in tandem with the value of the outstanding common stock.…”