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The integrated impact of credit and interest rate risk on banks: an economic value and capital adequacy perspective

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Mathias Drehmann
Steffen Sorensen
Marco Stringa

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Abstract

Credit and interest rate risk in the banking book are the two most important risks faced by commercial banks. In this paper we derive a consistent and general framework to measure the integrated impact of both risks on banks' portfolios. The framework accounts for all sources of credit risk and interest rate risk. By modelling the whole portfolio of a bank and by taking account of the repricing characteristics of all exposures, we can assess the impact of credit and interest rate risk not only on the bank's economic value but also on its future earnings and capital adequacy. We apply our framework to a hypothetical bank in normal and stressed conditions. The simulation highlights that it is fundamental to measure the impact of interest rate and credit risk jointly. We also show that it is crucial to model the whole portfolio, including the repricing and maturity characteristics of assets, liabilities and off balance sheet items.

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Paper provided by Bank of England in its series Bank of England working papers with number 339.

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Handle: RePEc:boe:boeewp:339

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  1. Norbert Jobst & Stavros A. Zenios, 2001. "Extending Credit Risk (Pricing) Models for the Simulation of Portfolios of Interest Rate and Credit Risk Sensitive Securities," Center for Financial Institutions Working Papers 01-25, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
  2. 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. [Downloadable!] (restricted)
  3. repec:fth:pennfi:67 is not listed on IDEAS
  4. Jarrow, Robert A. & Turnbull, Stuart M., 2000. "The intersection of market and credit risk," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 271-299, January. [Downloadable!] (restricted)
  5. Marshall E. Blume & Felix Lim & A. Craig MacKinlay, . "The Declining Credit Quality of US Corporate Debt: Myth or Reality?," Rodney L. White Center for Financial Research Working Papers 3-98, Wharton School Rodney L. White Center for Financial Research.
  6. Marshall E. Blume & Felix Lim & A. Craig Mackinlay, 1998. "The Declining Credit Quality of U.S. Corporate Debt: Myth or Reality?," Journal of Finance, American Finance Association, vol. 53(4), pages 1389-1413, 08. [Downloadable!] (restricted)
  7. Chen, Carl R & Chan, Anthony, 1989. "Interest Rate Sensitivity, Asymmetry, and the Stock Returns of Financial Institutions," The Financial Review, Eastern Finance Association, vol. 24(3), pages 457-73, August.
  8. 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, vol. 38(5), pages 1211-1261, August. [Downloadable!] (restricted)
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  9. Flannery, Mark J & James, Christopher M, 1984. " The Effect of Interest Rate Changes on the Common Stock Returns of Financial Institutions," Journal of Finance, American Finance Association, vol. 39(4), pages 1141-53, September. [Downloadable!] (restricted)
  10. Donald R. Fraser, 2002. "Sources of Bank Interest Rate Risk," The Financial Review, Eastern Finance Association, vol. 37(3), pages 351-367, 08. [Downloadable!] (restricted)
  11. Corvoisier, Sandrine & Gropp, Reint, 2002. "Bank concentration and retail interest rates," Journal of Banking & Finance, Elsevier, vol. 26(11), pages 2155-2189, November. [Downloadable!] (restricted)
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  12. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June. [Downloadable!] (restricted)
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  13. Marshall E. Blume & Felix Lim & A. Craig MacKinlay, . "The Declining Credit Quality of US Corporate Debt: Myth or Reality?," Rodney L. White Center for Financial Research Working Papers 03-98, Wharton School Rodney L. White Center for Financial Research.
  14. Diebold, Francis X. & Rudebusch, Glenn D. & Borag[caron]an Aruoba, S., 2006. "The macroeconomy and the yield curve: a dynamic latent factor approach," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 309-338. [Downloadable!] (restricted)
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  15. Sorge, Marco & Virolainen, Kimmo, 2006. "A comparative analysis of macro stress-testing methodologies with application to Finland," Journal of Financial Stability, Elsevier, vol. 2(2), pages 113-151, June. [Downloadable!] (restricted)
  16. Barnhill Jr., Theodore M. & Maxwell, William F., 2002. "Modeling correlated market and credit risk in fixed income portfolios," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 347-374, March. [Downloadable!] (restricted)
  17. Antje Berndt & Rohan Douglas & Darrell Duffie & Mark Ferguson, . "Measuring Default Risk Premia from Default Swap Rates and EDFs," GSIA Working Papers 2006-E31, Carnegie Mellon University, Tepper School of Business. [Downloadable!]
  18. David M. Wright & James V. Houpt, 1996. "An analysis of commercial bank exposure to interest rate risk," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Feb, pages 115-128.
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