Procyclicality in tradeable credit risk: Consequences for South Africa

Abstract

Background: Tradeable credit assets are vulnerable to two varieties of credit risk: default risk (which manifests itself as a binary outcome) and spread risk (which arises as spreads change continuously). Current (2017) regulatory credit risk rules require banks to hold capital for both these risks. Aggregating these capital amounts is non-trivial. Aim: The aim was to implement the bubble value at risk (buVaR) approach, proposed by Wong (2011) to overcome the risk aggregation problem. This method accounts for diversification and for procyclicality and operates by inflating the positive side of the underlying return distribution, in direct proportion to prevailing credit spread levels (usually liquid credit default swap spreads). Setting: The principal setting for the study was the South African credit market which represents a developing market. Previous work by Wong (2011) focussed only on developed markets. Methods: Using South African data, closed form solutions were derived for free parameters of Wong’s formulation, and the relationship between the spread level and the response function was developed and calibrated. Results: The results indicate that the original calibrations and assumptions made by Wong (2011) would result in excessive capital requirement for South African banks. Estimates obtained from this work suggest further calibration is required to cover the unique features of the South African milieu. Considerable differences compared with other markets were also found. Conclusion: The application of buVaR to South African government bond credit default swaps spreads highlighted the metric’s countercyclical properties that would potentially have countered bubble developments had they been implemented during the credit crisis of 2008/2009. Regulatory authorities should take this important metric into account when allocating South African bank’s credit risk capital.

Keywords

• credit risk
• value at risk
• bubble value at risk
• procyclical
• spread risk