Commercial Bank Charge Offs – The Need for a System View May 15 th , 2011
Key Points • Commercial Bank Asset Correlations Change in Time – Risk Diversification Changes in Time – Lack of Risk Diversity Can Hurt at the Wrong Time • Reversion to Trend Has Long Cycles • Views of Networks of Relationships are Needed – Asset Correlations Changing in Time – Client/Customer Cash Flows Changing in Time – Quasi and True Experimental Designs to Understand Network Effects – Cause and Effect Relationships Among Agents – Predictive not just Descriptive 2
Most Importantly: A Taxonomy of Uncertainty May Be In Order • Level 1: Complete Certainty • Level 2: Risk Without Uncertainty • Level 3: Fully Reducible Uncertainty • Level 4: Partially Reducible Uncertainty • Level 5: Irreducible Uncertainty • “Physics Envy May Be Hazardous to Your Wealth!,” Andrew W. Lo and Mark T. Mueller, March, 2010. • Video lecture available at http://http://mitworld.mit.edu/video/794 3 Source: Federal Reserve
Commercial Bank Asset Correlations Change in Time 4 Source: Federal Reserve
Reversion to Trend Has Long Cycles 5 Source: Federal Reserve
Views of Networks of Relationships are Needed (1/11) V ar i ous A sset C at egor i es show cor r el at i ons am ong t hem sel ves dur i ng any gi ven per i od of t i m e. F or exam pl e: L at e 191 t hr ough 192 show s st r ong, posi t i ve cor r el at i ons bet w een busi ness loans, leases and agricultural loans. T he business sector shows strength in this period with respect to charge offs – l ow er char ge- of f s ( gr een) m eans bet t er cr edi t w or t hi ness. N ot e: C C orrel at i ons are t i ed t o % of asset s charged of f i n each asset cl ass 6 Source: Federal Reserve
Views of Networks of Relationships are Needed (2/11) M i d 193 t hr ough begi nni ng of 195 have beni gn, posi t i ve cor r el at i ons. 7 Source: Federal Reserve
Views of Networks of Relationships are Needed (3/11) T her e i s a bi t of cr edi t det er i or at i on i n t he m i d- cycl e am ong consum er s. A di ver se por t f ol i o dam pens t he ef f ect on a por t f ol i o of bank l oans and l eases. 8 Source: Federal Reserve
Views of Networks of Relationships are Needed (4/11) A sset s ar e l ar gel y unchanged f r om m i d- 197 t hr ough t he begi nni ng of 19 . D i ver si f i cat i on cont i nues t o hel p. 9 Source: Federal Reserve
Views of Networks of Relationships are Needed (5/11) S trong positive correlations among deteriorating assets offer little diversification through the recession – bot h consum er and com m er ci al l oans and l eases det er i or at e. 10 Source: Federal Reserve
Views of Networks of Relationships are Needed (6/11) P ortfolios diversify a bit… 11 Source: Federal Reserve
Views of Networks of Relationships are Needed (7/11) P ositive benign correlations mark the mid-cycle once more… 12 Source: Federal Reserve
Views of Networks of Relationships are Needed (8/11) P ortfolios diversify a bit, but there is a bit of deterioration in some asset classes… 13 Source: Federal Reserve
Views of Networks of Relationships are Needed (9/11) A s went residential real estate, so went other assets through the credit and liquidity crisis… S t udyi ng dynam i c syst em r el at i onshi ps, especi al l y as agent s adapt w i t h new behavi or s, i s a pr om i si ng f r ont i er f or m anagi ng r i sk and opt i m i zi ng r i sk- adj ust ed r et ur ns 14 Source: Federal Reserve
Views of Networks of Relationships are Needed (10/11) P ositive benign correlations helped the recovery of bank balance sheets… 15 Source: Federal Reserve
Views of Networks of Relationships are Needed (11/11) P ositive benign correlations mark the mid-cycle once more… 16 Source: Federal Reserve
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