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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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File URL: http://repec.org/mmf2006/up.7768.1148292500.pdf
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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
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Handle: RePEc:mmf:mmfc06:151
Contact details of provider: Web page: http://www.essex.ac.uk/afm/mmf/index.html

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  1. Hans Dewachter, 2004. "Macro factors and the term structure of interest rates," Money Macro and Finance (MMF) Research Group Conference 2003 25, Money Macro and Finance Research Group.
  2. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
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  7. Francis X. Diebold & Glenn D. Rudebusch & S. Boragan Aruoba, 2004. "The Macroeconomy and the Yield Curve: A Dynamic Latent Factor Approach," NBER Working Papers 10616, National Bureau of Economic Research, Inc.
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  9. 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.
  10. Marco Sorge, 2004. "Stress-testing financial systems: an overview of current methodologies," BIS Working Papers 165, Bank for International Settlements.
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