Systemic bank risk in Brazil:an assessment of correlated market,credit, sovereign and inter-bank riskin an environment with stochasticvolatilities and correlations

In this study we develop and demonstrate a powerful and flexible forward-looking portfoliosimulation methodology for assessing the correlated impacts of market risk, and privatesector, sovereign and inter-bank default risk on both individual banks (i.e. 28 of the largestBrazilian banks) and groups of banks (i.e. the Brazilian banking system). The methodologyimportantly accounts for bank asset and liability maturity and currency mismatches and loanportfolio credit quality and sector and region concentrations. In a significant innovation,financial and economic environment variables are modeled with stochastic volatilities andcorrelations. We demonstrate the reliability of the models by comparing simulated andhistorical credit transition probabilities, simulated and historical bank rates of return, andsimulated versus actual bank credit ratings. When omitting sovereign risk our analysisindicates that none of the banks face significant default risk over a 1-year horizon. This lowdefault risk stems primarily from the large amount of government securities held by Brazilianbanks, but also reflects the banks’ adequate capitalizations and extraordinarily high interestrate spreads. Once sovereign risk is considered and losses in the market value of governmentsecurities reaches 10 percent (or higher), several banks face potential solvency problems.These results demonstrate the well known risk of concentrated lending to a borrower whichhas a non-zero probability of default (e.g. Government of Brazil). We also demonstrate thepotential systemic risk impact of variation in average recovery rates on defaulted privatesector loans which reflect, among other factors, bank lending policies, the efficiency of thelegal system in resolving defaults, and aggregate levels of defaults. Our analysis alsohighlights the importance of accounting for the differential risk characteristics of variousbanks and for the inter-bank risk channel, through which a systemic crisis may propagate. Itfurther indicates that, in the event of a sovereign de