Rethinking economic capital management through the integrated derivative-based treatment of interest rate and credit risk

Abstract

This research revisits the economic capital management regarding banking books of financial institutions exposed to the emerging market sovereign debt. We develop a derivative-based integrated approach to quantify economic capital requirements for considered jointly interest rate and credit risk. Our framework represents a major contribution to the empirical aspects of capital management. The proposed innovative modeling allows applying standard historic value-at-risk techniques developed for stand-alone risk factors to evaluate aggregate impacts of several risks. We use the time-series of credit default swap spreads and interest rate swap rates as proxy measures for credit risk and interest rate risk, respectively. An elasticity of interest rate risk and credit risk, considered a function of the business cycle phases, maturity of instruments, creditworthiness, and other macroeconomic parameters, is gauged by means of numerical modeling. Our contribution to the new economic thinking regarding the interest rate risk and credit rate risk management consists in their integrated treatment as the dynamics of interest rate and credit spreads is found to demonstrate the features of automatic stabilizers of each other. This research sheds light on how financial institutions may address hedge strategies against downside risks. It is of special importance for emerging markets heavily dependent on foreign capital as it potentially allows emerging market banks to improve risk management practices in terms of capital adequacy and Basel III rules. From the regulatory perspective, by taking into account inter-risk diversification effects it allows enhancing financial stability through jointly optimizing Pillar 1 and Pillar 2 economic capital. B Mariya Gubareva

Weight of the Default Component of CDS Spreads: Avoiding Procyclicality in Credit Loss Provisioning Framework

“…In recent times, the process of deriving PDs and ratings from CDS spreads has been widely discussed in the literature; see Heynderickx et al [18] and Jansen and Fabozzi [28] and references therein. Another research by Gubareva and Borges [16] is also related to our work, where CDS spreads are used as a proxy for credit risk metrics while addressing economic capital optimization strategies.…”

“…These CDS instruments, even though recognized off balance sheet, still result in capital consumption incurred by financial institutions. Consequently, the necessity to hold a capital affects CDS prices and spreads; see Gubareva and Borges [16].…”

“…It is worth noting that CDS spreads are commonly used in the literature to proxy credit risk. For additional reading, related to the use of CDS quotes for economic capital management, see Gubareva and Borges [16] and the references therein. Another case for CDS use is that CDS is also a very efficient and sensitive instrument to measure credit risk.…”

Binary interest rate sensitivities of emerging market corporate bonds

“…Not surprisingly, there is a growing volume of scientific research addressing the effects of interest rate changes on bank performance and solvency. See, for example, Berends et al (2013), Neal et al (2015), Dupoyet, Jiang, and Zhang (2016), Gubareva and Borges (2016), Gubareva and Borges (2017), and references therein.…”

The Credit Asset of Enterprise Accounts Receivable Pricing Model

“…In 2017, Bahadir and Valev [12] provided evidence for convergence in the levels of household and business credit. In 2018, Gubareva and Borges [13] developed a derivative-based integrated approach to quantify economic capital requirements on interest rate and credit risk. In 2018, Jia et al [14] explored factors that are attractive for consumers and thereafter affect their use of ecommerce consumer credit services.…”