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Liquidity risk, credit risk, market risk and bank capital

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  • Simone Varotto

Abstract

Purpose - The purpose of this paper is to investigate the relationship between liquidity and credit risk, and employ the findings to estimate the Incremental Risk Charge (IRC), the new credit risk capital add-on introduced by the Basel Committee for banks' trading books. The IRC estimates are compared with stressed market risk measures, derived from a sample of corporate bond indices encompassing the recent financial crisis. This can determine the extent to which trading book capital would change in stress conditions, under newly proposed rules. Design/methodology/approach - The Basel II and the proposed Basel III capital requirements for banks' trading books, with a sample of bond portfolios, are implemented. Findings - The findings show that, although the (incremental) credit risk in the trading book may be considerable, the capital needed to absorb market risk-related losses in stressed scenarios can be more than ten times larger. Originality/value - The data, methodology and purpose are all original.

Suggested Citation

  • Simone Varotto, 2011. "Liquidity risk, credit risk, market risk and bank capital," International Journal of Managerial Finance, Emerald Group Publishing, vol. 7(2), pages 134-152, April.
  • Handle: RePEc:eme:ijmfpp:v:7:y:2011:i:2:p:134-152
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    References listed on IDEAS

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    1. Juan-Ángel Jiménez-Martín & Michael McAleer & Teodosio Pérez-Amaral, 2009. "The Ten Commandments For Managing Value At Risk Under The Basel Ii Accord," Journal of Economic Surveys, Wiley Blackwell, vol. 23(5), pages 850-855, December.
    2. Jianming Kou & Simone Varotto, 2008. "Timeliness of Spread Implied Ratings," European Financial Management, European Financial Management Association, vol. 14(3), pages 503-527.
    3. M.J.B. Hall, 1996. "The amendment to the capital accord to incorporate market risk," Banca Nazionale del Lavoro Quarterly Review, Banca Nazionale del Lavoro, vol. 49(197), pages 271-277.
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    5. Carey, Mark & Hrycay, Mark, 2001. "Parameterizing credit risk models with rating data," Journal of Banking & Finance, Elsevier, vol. 25(1), pages 197-270, January.
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    7. Pérignon, Christophe & Smith, Daniel R., 2010. "The level and quality of Value-at-Risk disclosure by commercial banks," Journal of Banking & Finance, Elsevier, vol. 34(2), pages 362-377, February.
    8. Christophe Perignon & D. Smith, 2009. "The Level and Quality of Value-at-Risk Disclosure by Commercial Banks," Post-Print hal-00496102, HAL.
    9. Berg, Tobias, 2010. "The term structure of risk premia: new evidence from the financial crisis," Working Paper Series 1165, European Central Bank.
    10. Michael McAleer, 2009. "The Ten Commandments For Optimizing Value-At-Risk And Daily Capital Charges," Journal of Economic Surveys, Wiley Blackwell, vol. 23(5), pages 831-849, December.
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    Cited by:

    1. Eduardo Viegas & Misako Takayasu & Wataru Miura & Koutarou Tamura & Takaaki Ohnishi & Hideki Takayasu & Henrik Jeldtoft Jensen, 2013. "Ecosystems perspective on financial networks: diagnostic tools," Papers 1301.5821, arXiv.org.
    2. Giovanni Pepe, 2013. "Basel 2.5: potential benefits and unintended consequences," Questioni di Economia e Finanza (Occasional Papers) 159, Bank of Italy, Economic Research and International Relations Area.
    3. repec:eee:ecmode:v:64:y:2017:i:c:p:48-59 is not listed on IDEAS

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