An economic capital model integrating credit and interest rate risk in the banking book

Abstract

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How do banks make the trade-offs among risks? The role of corporate governance

“…Carling et al (2007) argue that interest rate changes affect the credit quality of assets, while Drehmann et al (2010) report that a risk assessment should measure the integrated effect of credit and interest rate risks by using a stress test judged by the economic value and capital adequacy of banks. The results obtained by Alessandri and Drehmann (2010) confirm that the interaction between credit and interest rate risks matters. The simulations of this previous study show that great interest rate risk exposure would increase the credit risk encountered by a bank, which of runs.…”

“…Duffie and Singleton (2003) also provide an overview of credit risk pricing, measurement, and management. 4 Concurrent literature has concentrated on analyzing the various approaches used to assess interest rate exposure of banks. These approaches can be classified into two types (i.e., current earnings or economic value perspective).…”

Interaction of market and credit risk

“…Diversification gains are clearly possible, and whether risk diversification or risk compounding effects dominate is case-specific. 11 An example where calculating market and credit risk separately and then summing the risks may be conservative -overestimating total risk -is provided by Alessandri and Drehmann (2010). They analyze interactions between interest rate risk and default risk in the banking book, applying the stress testing framework for a representative UK bank (an average of the top-10 UK banks) by Drehmann et al (2010).…”

“…Moreover, an integrated approach requires that all gains and losses be captured in a consistent way across the two types of risk. Compared with approaches often encountered in practice, adjustments may be necessary, for example to consider not only losses on held-to-maturity loan portfolios but also (interest) earnings (as is also done for example in Alessandri and Drehmann, 2010;Drehmann et al, 2010). What is clear is that, as a consequence of the strong non-linear relationships that can be present between market and credit risk, ''top-down" aggregation approaches are subject to significant errors relative to ''bottomup" approaches, suggesting that risk managers should make great efforts to move in the direction of a more integrated measurement and management of different risks.…”

The integrated impact of credit and interest rate risk on banks: A dynamic framework and stress testing application

“…Although we do not distinguish whether assets and liabilities are on or off balance sheet items in this section, we will model them separately in our stress test application.11 For a discussion of this assumption seeAlessandri and Drehmann (2010). 12 This is a standard assumption in credit risk models implemented for day to day risk management, even though recent research has shown that it does not necessarily hold (e.g.…”