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Integrating credit and interest rate risk: A theoretical framework and an application to banks' balance sheets

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Author Info

  • Mathias Drehmann

    ()
    (Systemic Risk Assessment Division, Bank of England)

  • Steffen Sorensen

    (Systemic Risk Assessment Division, Bank of England)

  • Marco Stringa

    (Systemic Risk Assessment Division, Bank of England)

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 riskiness of a bank which is subject to correlated interest rate and credit risk. The framework accounts for all sources of credit risk, interest rate risk and their combined impact As we model the whole balance sheet of a bank the framework not only enables us to assess the impact of credit and interest rate risk 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 correlated interest rate and credit risk jointly on the whole portfolio of banks, including assets, liabilities and off-balance sheet items

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File URL: http://repec.org/mmf2006/up.7768.1148292500.pdf
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Bibliographic Info

Paper provided by Money Macro and Finance Research Group in its series Money Macro and Finance (MMF) Research Group Conference 2006 with number 151.

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Date of creation: 02 Feb 2007
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Handle: RePEc:mmf:mmfc06:151

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Web page: http://www.essex.ac.uk/afm/mmf/index.html

Related research

Keywords: Integration of credit risk & interest rate risk; asset & liability management of banks; economic value; stress testing;

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  1. DeAngelo, Harry & DeAngelo, Linda & Skinner, Douglas J., 2000. "Special dividends and the evolution of dividend signaling," Journal of Financial Economics, Elsevier, vol. 57(3), pages 309-354, September.
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  9. Marco Sorge, 2004. "Stress-testing financial systems: an overview of current methodologies," BIS Working Papers 165, Bank for International Settlements.
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Cited by:
  1. Loser, Claudio M. & Kiguel, Miguel A. & Mermelstein, David, 2010. "A Macroprudential Framework for the Early Detection of Banking Problems in Emerging Economies," Working Papers on Regional Economic Integration 44, Asian Development Bank.
  2. Mizuho Kida, 2008. "A macro stress testing model with feedback effects," Reserve Bank of New Zealand Discussion Paper Series DP2008/08, Reserve Bank of New Zealand.
  3. Nguenang, Christian & Kamgna, Sévérin yves & Tinang, Nzeusseu Jules, 2010. "Une approche Macroprudentielle du risque systémique en zone CEMAC
    [A Macro-prudential approach of systemic risk in CEMAC zone]
    ," MPRA Paper 25632, University Library of Munich, Germany.
  4. Sokolov, Yuri, 2012. "Modeling risk in a dynamically changing world: from association to causation," MPRA Paper 40096, University Library of Munich, Germany.

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