Banking Systems Simulation

Theory, Practice, and Application of Modeling Shocks, Losses, and Contagion

Stefano Zedda

• Publisher: Wiley
• Year: 2017
• Print ISBN: 9781119195894
• eBook ISBN: 9781119195917
• Edition: 1
• Topic: Mathematics
• Subtopic: Probability & Statistics
• Index: Mathematics

Presents information sources and methodologies for modeling and simulating banking system stability

Combining both academic and institutional knowledge and experience, Banking Systems Simulation: Theory, Practice, and Application of Modeling Shocks, Losses, and Contagion presents banking system risk modeling clearly within a theoretical framework. Written from the global financial perspective, the book explores single bank risk, common bank exposures, and contagion, and how these apply on a systemic level. Zedda approaches these simulation methods logically by providing the basic building blocks of modeling and simulation, and then delving further into the individual techniques that make up a systems model.

In addition, the author provides clear and detailed explanations of the foundational research into the mathematical and legal concepts used to analyze banking risk problems, measures and data for representing the main banking risk sources, and the major problems researchers are likely to encounter. There are numerous software descriptions throughout, with references and tools to help readers gain a proper understanding of the presented techniques and possibly develop new applications and research. The book concludes with an appendix that features real-world datasets and models.

In addition, this book:

• Provides a comprehensive overview of methods for analyzing models and simulating risk for banking and financial systems

• Provides a clear presentation of the technical and legal concepts used in banking regulation

• Presents unique insights from an expert's perspective, with specific coverage of assessing risks and developing what-if analyses at the systems level

• Concludes with a discussion of applications, including banking systems regulation what-if tests, cost-benefit analysis, evaluations of banking systems stability effects on public finances, dimensioning, and risk-based contributions for Deposit Guarantee Schemes (DGS) and Resolution Funds

Banking Systems Simulation: Theory, Practice, and Application of Modeling Shocks, Losses, and Contagion is ideal for banking researchers focusing on computational methods of analysis as well as an appropriate reference for graduate-level students in banking, finance, and computational methods.

Stefano Zedda is Researcher in Financial Mathematics at the University of Cagliari in Italy and qualified as associate professor in banking and corporate finance. His research is mainly focused on quantitative analyses for banking and finance, with a particular focus on banking systems modeling and simulation. In 2008, Zedda developed the mathematical modeling and software implementation of the Systemic Model for Banking Originated Losses (SYMBOL), further developed during his activity at the European Commission. The Commission subsequently adopted it as a standard tool for testing banking regulation proposals. Stefano Zedda's research interests include banking, financial mathematics, and statistics, specifically simulation of banking and financial systems stability, banking regulation impact assessment, and interactive agent simulation.

1
Banking Risk

A bank's core business, credit activity, is centered on borrowing and lending, thus mainly dealing with two components: money and risks.

The first component, money, seems to be the simplest to measure, as all balance sheets and income statements report only money values. In fact, the different contracts, timing, and liquidity require much more attention than expected.

Every economic activity implicitly includes risk, as the economic framework always includes uncertainty. But a bank's activity is centered on risk, as its core business is in borrowing money, and lending it, bearing all risks of counterpart: default, maturity transformation, market values variation, liquidity, and so on.

Diverse layers of bank activity are cross-linked, and take part in maintaining the equilibriums in terms of revenue, economic stability, and operational activity. As a consequence, the bank's activity analysis is always complex.

The ways for analyzing credit activity are multiple.

On one hand, the banking activity is a specification of firms management, so it can be analyzed with the same attitude in terms of internal processes, costs and income, business models, personnel management, and so on.

Another possibility is to evaluate the activity results of banks from the outside, by means of regression analyses, so as to find a posteriori a description of their actual activity, results, and business models distribution and evolution.

Banks play a key role in financing the real economy, thereby sustaining and promoting the economic growth; their activity is often considered to be of national interest, and in some countries it is directly held by public companies.

In fact, the credit support of a firm or sector can substantially change its evolution and growth; choosing which firm to finance or which sector to support can be in some cases more effective than some public policy interventions.

Other fundamental aspects of banks activity are related to the volume of money managed in stock exchange and bonds markets, where the buying and selling activity can significantly affect values. Even when considering issuers of large dimensions, as in the case of sovereign bonds, the bank's attitude to buying or holding bonds to maturity can be of fundamental importance, and often the interest of governments in keeping the availability of banks in this can sometimes affect the government policy toward the banking sector.

This key role in sustaining the economic growth and the fact that banks are typically large firms induces specific attention toward the bank's activity, as the banks' default not only stops the support of economic growth but also can induce huge effects of market instability, lack of confidence in banks and in savings, bank runs, and disruptive effects on the real economy.

Thus, the analysis of a bank's activity, and of its different layers and interconnections, and the supervision and regulation of banks, are of fundamental importance for preserving savers' confidence in banks, the bank's action in channeling savings to firms, thus sustaining economic growth and preserving economic and financial stability.

The credit activity also carries a specific characteristic, as it involves buying and selling money—different maturity, contracts, risks, but always money. There is no actual goods production or transformation. This simplifies some aspects, but also induces a greater interrelationship between the different activity layers; so, as an example, there can be no strict separation, as it happens in industrial or commercial activities, between real goods or services production, and financial activities.

At a first glance, a bank's balance sheet seems to be quite similar to any other firm's balance sheet: The assets side mainly includes customer loans, bonds, interbank credits, and some other assets such as cash, buildings, and so on. As banks do not buy, transform, or sell goods, there is no motivation for quantifying the values of goods at the beginning and end of each year. The liabilities side includes deposits, interbank debts, issued bonds, and capital.

A more significant difference with respect to nonfinancial activities, such as the industrial activity, appears when comparing the assets side with the income statement: For banks, the total revenue is only a fraction of total assets, while industries typically register sales revenues in value closer to the total assets.

As an example, the FCA 2015 group's consolidated balance sheet¹ reports total assets of €105,040 million, equity of 16,255 (15.5% of TA), and net revenues of €110,595 million (105% of TA), while the Deutsche Bank 2015 balance sheet² reports total assets of €1,436,029 million, capital of 45,828 (3.2% of TA), and main income values (interest income, current income, commission income, and other operating income) summing up to a total of €31,086 million, around 2% of total assets.

It is evident that when analyzing a bank's activity, our attention is more on the assets volume than on income. It is worth noting that Germany's GDP for 2015 was estimated to be €3,025,900 million,³ while Deutsche Bank's total assets in 2015 were about 47% of its home country's GDP.

This assets dimension also explains why risks are so significant in banking activity. Referring to the values above, a reduction of 3.5% in value for FCA assets will reduce the equity value ...

Table of contents

• Cover
• Wiley Series in Modeling and Simulation
• Title Page
• Copyright
• Dedication
• Foreword
• Introduction
• Chapter 1: Banking Risk
• Chapter 2: Simulation Models
• Chapter 3: Real Economy, Sovereign Risk, and Banking Systems Linkages
• Chapter 4: Applications
• Appendix: Software References and Tools
• References
• Index
• End User License Agreement