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

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  • Alessandri, Piergiorgio

    ()
    (Bank of England)

  • Drehmann, Mathias

    ()
    (Bank for International Settlements)

Abstract

Banks often measure credit and interest rate risk separately and then add the two risk measures to determine their overall economic capital. This approach misses complex interactions between the two risks. We develop a framework where credit and interest rate risks are analysed jointly. We focus on a traditional banking book where all positions are held to maturity and subject to book value accounting. Our simulations show that interactions between risks matter, and that their implications depend on the structure of the balance sheet and on the repricing characteristics of assets and liabilities. The analysis suggests that a joint analysis of risks can deliver substantially different results relative to a piece-wise approach: risk integration is challenging but feasible and worthwhile.

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Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 388.

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Length: 36 pages
Date of creation: 01 Jun 2010
Date of revision:
Handle: RePEc:boe:boeewp:0388

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Keywords: Economic capital; risk management; credit risk; interest rate risk; asset and liability management;

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References

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  1. Michael B. Gordy, 1998. "A comparative anatomy of credit risk models," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 1998-47, Board of Governors of the Federal Reserve System (U.S.).
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  4. Pesaran, M. Hashem & Schuermann, Til & Treutler, Bjorn-Jakob & Weiner, Scott M., 2006. "Macroeconomic Dynamics and Credit Risk: A Global Perspective," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 38(5), pages 1211-1261, August.
  5. Mathias Drehmann & Steffen Sorensen & Marco Stringa, 2008. "The integrated impact of credit and interest rate risk on banks: an economic value and capital adequacy perspective," Bank of England working papers 339, Bank of England.
  6. Drehmann, Mathias & Sorensen, Steffen & Stringa, Marco, 2010. "The integrated impact of credit and interest rate risk on banks: A dynamic framework and stress testing application," Journal of Banking & Finance, Elsevier, vol. 34(4), pages 713-729, April.
  7. Frey, Rudiger & McNeil, Alexander J., 2002. "VaR and expected shortfall in portfolios of dependent credit risks: Conceptual and practical insights," Journal of Banking & Finance, Elsevier, vol. 26(7), pages 1317-1334, July.
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  10. Alessandri, Piergiorgio & Drehmann, Mathias, 2010. "An economic capital model integrating credit and interest rate risk in the banking book," Bank of England working papers 388, Bank of England.
  11. Egloff, Daniel & Leippold, Markus & Vanini, Paolo, 2007. "A simple model of credit contagion," Journal of Banking & Finance, Elsevier, vol. 31(8), pages 2475-2492, August.
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  15. Jobst, Norbert J. & Mitra, Gautam & Zenios, Stavros A., 2006. "Integrating market and credit risk: A simulation and optimisation perspective," Journal of Banking & Finance, Elsevier, vol. 30(2), pages 717-742, February.
  16. Corvoisier, Sandrine & Gropp, Reint, 2001. "Bank Concentration and Retail Interest Rates," Working Paper Series, European Central Bank 0072, European Central Bank.
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  18. Piergiorgio Alessandri & Prasanna Gai & Sujit Kapadia & Nada Mora & Claus Puhr, 2009. "Towards a Framework for Quantifying Systemic Stability," International Journal of Central Banking, International Journal of Central Banking, International Journal of Central Banking, vol. 5(3), pages 47-81, September.
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Citations

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Cited by:
  1. Pejman Abedifar & Philip Molyneux & Amine Tarazi, 2013. "Risk in Islamic Banking," Review of Finance, European Finance Association, European Finance Association, vol. 17(6), pages 2035-2096.
  2. Bellini, Tiziano, 2013. "Integrated bank risk modeling: A bottom-up statistical framework," European Journal of Operational Research, Elsevier, Elsevier, vol. 230(2), pages 385-398.
  3. Alessandri, Piergiorgio & Nelson, Benjamin, 2012. "Simple banking: profitability and the yield curve," Bank of England working papers 452, Bank of England.
  4. Drehmann, Mathias & Sorensen, Steffen & Stringa, Marco, 2010. "The integrated impact of credit and interest rate risk on banks: A dynamic framework and stress testing application," Journal of Banking & Finance, Elsevier, vol. 34(4), pages 713-729, April.
  5. Alessandri, Piergiorgio & Drehmann, Mathias, 2010. "An economic capital model integrating credit and interest rate risk in the banking book," Journal of Banking & Finance, Elsevier, vol. 34(4), pages 730-742, April.
  6. Kretzschmar, Gavin & McNeil, Alexander J. & Kirchner, Axel, 2010. "Integrated models of capital adequacy - Why banks are undercapitalised," Journal of Banking & Finance, Elsevier, vol. 34(12), pages 2838-2850, December.
  7. Pejman Abedifar & Philip Molyneux & Amine Tarazi, 2014. "Non-Interest Income Activities and Bank Lending," Working Papers hal-00947074, HAL.
  8. Memmel, Christoph, 2011. "Banks' exposure to interest rate risk, their earnings from term transformation, and the dynamics of the term structure," Journal of Banking & Finance, Elsevier, vol. 35(2), pages 282-289, February.
  9. Baldan, Cinzia & Zen, Francesco & Rebonato, Tobia, 2012. "Liquidity risk and interest rate risk on banks: are they related?," MPRA Paper 41323, University Library of Munich, Germany.
  10. Buch, Arne & Dorfleitner, Gregor & Wimmer, Maximilian, 2011. "Risk capital allocation for RORAC optimization," Journal of Banking & Finance, Elsevier, vol. 35(11), pages 3001-3009, November.
  11. Hongbiao Zhao, 2011. "Portfolio credit risk of default and spread widening," LSE Research Online Documents on Economics 43451, London School of Economics and Political Science, LSE Library.
  12. Andre Lucas & Bastiaan Verhoef, 2012. "Aggregating Credit and Market Risk: The Impact of Model Specification," Tinbergen Institute Discussion Papers 12-057/2/DSF36, Tinbergen Institute.
  13. Blöchlinger, Andreas, 2011. "Arbitrage-free credit pricing using default probabilities and risk sensitivities," Journal of Banking & Finance, Elsevier, vol. 35(2), pages 268-281, February.
  14. Andre Lucas & Bastiaan Verhoef, 2012. "Aggregating Credit and Market Risk: The Impact of Model Specification," Tinbergen Institute Discussion Papers 12-057/2/DSF36, Tinbergen Institute.

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