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

Author

Listed:
  • 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

Suggested Citation

  • Mathias Drehmann & Steffen Sorensen & Marco Stringa, 2007. "Integrating credit and interest rate risk: A theoretical framework and an application to banks' balance sheets," Money Macro and Finance (MMF) Research Group Conference 2006 151, Money Macro and Finance Research Group.
  • Handle: RePEc:mmf:mmfc06:151
    as

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    File URL: http://repec.org/mmf2006/up.7768.1148292500.pdf
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    References listed on IDEAS

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    1. Nicola Anderson & John Sleath, 2001. "New estimates of the UK real and nominal yield curves," Bank of England working papers 126, Bank of England.
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    3. Orla May & Merxe Tudela, 2005. "When is mortgage indebtedness a financial burden to British households? A dynamic probit approach," Bank of England working papers 277, Bank of England.
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    7. Bekaert, Geert & Wu, Guojun, 2000. "Asymmetric Volatility and Risk in Equity Markets," Review of Financial Studies, Society for Financial Studies, vol. 13(1), pages 1-42.
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    10. 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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    Citations

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    Cited by:

    1. Sokolov, Yuri, 2012. "Modeling risk in a dynamically changing world: from association to causation," MPRA Paper 40096, University Library of Munich, Germany.
    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. 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.
    5. David A. Mermelstein, 2017. "Hacia un indicador de vulnerabilidad bancaria basado en pruebas de estrés," CEMA Working Papers: Serie Documentos de Trabajo. 610, Universidad del CEMA.

    More about this item

    Keywords

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

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General

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