Template-type: ReDIF-Paper 1.0
Author-Name: Álvaro Chamizo
Author-Workplace-Name: BBVA.
Author-Name: Alexandre Fonollosa
Author-Workplace-Name: BBVA.
Author-Name: Alfonso Novales
Author-Workplace-Name: Instituto Complutense de Análisis Económico (ICAE), and Department of Economic Analysis, Facultad de Ciencias Económicas y Empresariales, Universidad 
	Complutense, 28223 Madrid, Spain.
Title: Forward-looking asset correlations in the estimation of economic capital
Abstract: We analyze whether the credit market anticipated the financial crisis before the regulators using a methodology that combines the Merton model for the determination 
	of economic capital with Vasicek’s factor model for asset correlation. Contrary to standard practice, we estimate the credit value at risk (VaR) and expected shortfall 
	(ES) of a global loan portfolio using CDS spreads because credit derivat- ives incorporate forward-looking information on future systemic shocks that might be 
	essential in the estimation of economic capital. We find that one-factor model can generally be a good representation of correlations in the credit market because of 
	the high inter-sector correlations, although an appro- priately chosen second factor can provide additional information for risk estimation in stressed times. We show 
	that there were, indeed, signs of stress in the credit market that were not incorporated in the determination of economic capital during the crisis and that some 
	financial institutions did not con- sider properly. The overall impression is that it is not so much that risk models were over-simplified to anticipate the financial 
	crisis but rather, that they were backward-looking. A potential implication of our research is that the level of regulatory capital should react to events in the 
	credit market.
Classification-JEL: E47, G01, G28, G32.
Keywords: Forward-looking Asset Correlation; Economic Capital; Asset Allocation; Systemic Risk.
Length: 48 pages 
Creation-Date: 2019-09
Number: 2019-25
X-File-Ref: http://america.sim.ucm.es/repec/ucm/ref/doicae1925.txt
File-URL: https://eprints.ucm.es/id/eprint/57131/1/1925.pdf
File-Format: Application/pdf
Handle: RePEc:ucm:doicae:1925