Commercial Bank Charge Offs The Need for a System View May 15 th , - - PowerPoint PPT Presentation

Commercial Bank Charge Offs – The Need for a System View

May 15th, 2011

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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

Most Importantly: A Taxonomy of Uncertainty May Be In Order

Source: Federal Reserve

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• 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

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Commercial Bank Asset Correlations Change in Time

Source: Federal Reserve

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Reversion to Trend Has Long Cycles

Source: Federal Reserve

Views of Networks of Relationships are Needed (1/11)

Source: Federal Reserve

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Var i ous Asset Cat egor i es show cor r el at i ons am

• ng t hem

sel ves dur i ng any gi ven per i od of t i m e. For exam pl e: Lat 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. The business sector shows

strength in this period with respect to charge offs – l ow er char ge-

• f f s ( gr een) m

eans bet t er cr edi t w

• r t hi ness.

Not e: C Correl at i ons are t i ed t o %

• f asset s charged of f i n each

asset cl ass

Views of Networks of Relationships are Needed (2/11)

Source: Federal Reserve

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Mi d 193 t hr ough begi nni ng of 195 have beni gn, posi t i ve cor r el at i ons.

Views of Networks of Relationships are Needed (3/11)

Source: Federal Reserve

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Ther 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

• ng 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.

Views of Networks of Relationships are Needed (4/11)

Source: Federal Reserve

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Asset s ar e l ar gel y unchanged f r om m i d- 197 t hr ough t he begi nni ng

• f 19. Di ver si f i cat i on cont i nues

t o hel p.

Views of Networks of Relationships are Needed (5/11)

Source: Federal Reserve

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Strong 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.

Views of Networks of Relationships are Needed (6/11)

Source: Federal Reserve

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Portfolios diversify a bit…

Views of Networks of Relationships are Needed (7/11)

Source: Federal Reserve

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Positive benign correlations mark the mid-cycle once more…

Views of Networks of Relationships are Needed (8/11)

Source: Federal Reserve

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Portfolios diversify a bit, but there is a bit of deterioration in some asset classes…

Views of Networks of Relationships are Needed (9/11)

Source: Federal Reserve

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As went residential real estate, so went other assets through the credit and liquidity crisis… St 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

• pt i m

i zi ng r i sk- adj ust ed r et ur ns

Views of Networks of Relationships are Needed (10/11)

Source: Federal Reserve

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Positive benign correlations helped the recovery of bank balance sheets…

Views of Networks of Relationships are Needed (11/11)

Source: Federal Reserve

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Positive benign correlations mark the mid-cycle once more…