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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

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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File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2008/WP339.pdf
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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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Date of creation: Jan 2008
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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.
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  5. repec:sae:niesru:v:139:y::i:1:p:88-94 is not listed on IDEAS
  6. Pesaran, M.H. & Schuermann, T. & Treutler, B-J. & Weiner, S.M., 2003. "Macroeconomic Dynamics and Credit Risk: A Global Perspective," Cambridge Working Papers in Economics 0330, Faculty of Economics, University of Cambridge.
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  9. 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.
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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.
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  14. repec:fth:pennfi:67 is not listed on IDEAS
  15. 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.
  16. Donald R. Fraser, 2002. "Sources of Bank Interest Rate Risk," The Financial Review, Eastern Finance Association, vol. 37(3), pages 351-367, 08.
  17. 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.
  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.
  19. Maurizio Luisi & Jeffery D. Amato, 2006. "Macro factors in the term structure of credit spreads," BIS Working Papers 203, Bank for International Settlements.
  20. 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.
  21. Nicola Anderson & John Sleath, 2001. "New estimates of the UK real and nominal yield curves," Bank of England working papers 126, Bank of England.
  22. 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.
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Cited by:

  1. Lucia Esposito & Andrea Nobili & Tiziano Ropele, 2013. "The management of interest rate risk during the crisis: evidence from Italian banks," Temi di discussione (Economic working papers) 933, Bank of Italy, Economic Research and International Relations Area.
  2. Zuzana Fungacova & Petr Jakubik, 2013. "Bank Stress Tests as an Information Device for Emerging Markets: The Case of Russia," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 63(1), pages 87-105, March.
  3. Hałaj, Grzegorz, 2013. "Optimal asset structure of a bank - bank reactions to stressful market conditions," Working Paper Series 1533, European Central Bank.
  4. Claudio Borio & Mathias Drehmann, 2011. "Toward an Operational Framework for Financial Stability: “Fuzzy” Measurement and Its Consequences," Central Banking, Analysis, and Economic Policies Book Series, in: Rodrigo Alfaro (ed.), Financial Stability, Monetary Policy, and Central Banking, edition 1, volume 15, chapter 4, pages 063-123 Central Bank of Chile.
  5. 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.
  6. David Aikman & Piergiorgio Alessandri & Bruno Eklund & Prasanna Gai & Sujit Kapadia & Elizabeth Martin & Nada Mora & Gabriel Sterne & Matthew Willison, 2009. "Funding Liquidity Risk in a Quantitative Model of Systemic Stability," Working Papers Central Bank of Chile 555, Central Bank of Chile.
  7. Kapadia, Sujit & Drehmann, Mathias & Elliott, John & Sterne, Gabriel, 2012. "Liquidity risk, cash-flow constraints and systemic feedbacks," Bank of England working papers 456, Bank of England.
  8. repec:hhs:bofitp:2012_003 is not listed on IDEAS
  9. 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.
  10. Spyros Pagratis & Marco Stringa, 2009. "Modeling Bank Senior Unsecured Ratings: A Reasoned Structured Approach to Bank Credit Assessment," International Journal of Central Banking, International Journal of Central Banking, vol. 5(2), pages 1-39, June.
  11. Iris Biefang Frisancho-Mariscal & Peter Howells, 2010. "Interest rate pass-through and risk," Working Papers 1016, Department of Accounting, Economics and Finance, Bristol Business School, University of the West of England, Bristol.
  12. Darne, O. & Levy-Rueff, O. & Pop, A., 2013. "Calibrating Initial Shocks in Bank Stress Test Scenarios: An Outlier Detection Based Approach," Working papers 426, Banque de France.
  13. Christian Schmieder & Maher Hasan & Claus Puhr, 2011. "Next Generation Balance Sheet Stress Testing," IMF Working Papers 11/83, International Monetary Fund.
  14. Haldane, Andrew & Hall, Simon & Pezzini, Silvia, 2007. "Financial Stability Paper No 2: A New Approach to Assessing Risks to Financial Stability," Bank of England Financial Stability Papers 2, Bank of England.
  15. Elisa Cavezzali & Gloria Gardenal, 2015. "Risk governance and performance of the Italian banks: an empirical analysis," Working Papers 8, Department of Management, Università Ca' Foscari Venezia.

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