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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.

Suggested Citation

  • 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.
  • Handle: RePEc:boe:boeewp:339
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    File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2008/WP339.pdf
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    Cited by:

    1. repec:rss:jnljef:v4i7p1 is not listed on IDEAS
    2. 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.
    3. David Aikman & Piergiorgio Alessandri & Bruno Eklund & Prasanna Gai & Sujit Kapadia & Elizabeth Martin & Nada Mora & Gabriel Sterne & Matthew Willison, 2011. "Funding Liquidity Risk in a Quantitative Model of Systemic Stability," Central Banking, Analysis, and Economic Policies Book Series,in: Rodrigo Alfaro (ed.), Financial Stability, Monetary Policy, and Central Banking, edition 1, volume 15, chapter 12, pages 371-410 Central Bank of Chile.
    4. Christian Schmieder & Maher Hasan & Claus Puhr, 2011. "Next Generation Balance Sheet Stress Testing," IMF Working Papers 11/83, International Monetary Fund.
    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. 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.
    7. Sujit Kapadia & Matthias Drehmann & John Elliott & Gabriel Sterne, 2012. "Liquidity Risk, Cash Flow Constraints, and Systemic Feedbacks," NBER Chapters,in: Quantifying Systemic Risk, pages 29-61 National Bureau of Economic Research, Inc.
    8. repec:ege:journl:v:17:y:2017:i:4:p:449-459 is not listed on IDEAS
    9. Esposito, Lucia & Nobili, Andrea & Ropele, Tiziano, 2015. "The management of interest rate risk during the crisis: Evidence from Italian banks," Journal of Banking & Finance, Elsevier, vol. 59(C), pages 486-504.
    10. 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.
    11. 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.
    12. 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.
    13. 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.
    14. 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.
    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.
    16. Hałaj, Grzegorz, 2013. "Optimal asset structure of a bank - bank reactions to stressful market conditions," Working Paper Series 1533, European Central Bank.

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