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Abstract
In this study, we present a comprehensive forward-looking portfolio simulation methodology for assessing the correlated impacts of market risk, private sector and sovereign credit risk, and interbank default risk. In order to produce better integrated risk assessment for banks and systemic risk assessments for financial systems, we argue that reasonably detailed modeling of bank asset and liability structures, loan portfolio credit quality, and loan concentrations by sector, region, and type, as well as a number of financial and economic environment risk drivers, is required. Sovereign and interbank default risks are increasingly important in the current economic environment, and their inclusion is an important model extension. This extended model is demonstrated through an application to both individual Brazilian banks (i.e., 28 of the largest banks) and groups of banks (i.e., the Brazilian banking system) as of December 2004. Our results also show that a commonly used approach of aggregating all banks into one single bank for purposes of undertaking a systemic banking system risk assessment results in a misestimation of both the probability and cost of systemic banking system failures. Our analysis also indicates that, in the event of a sovereign default, the Government of Brazil would face constrained debt management alternatives. We conclude that such forward-looking risk assessment methodologies for assessing multiple correlated risks, combined with the targeted collection of specific types of data on bank portfolios, have the potential to better quantify overall bank and banking system risk levels, which can assist bank management, bank regulators, sovereigns, rating agencies, and investors to make better informed and proactive risk management and investment decisions.
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