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

  • 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)

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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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
Date of revision:
Handle: RePEc:mmf:mmfc06:151
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  8. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
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