Ebook Conference on the Interaction of Market and Credit Risk
The view expressed by the Basel Committee in the Basel II capital accord receives strong support from the data. After credit risk, interest rate risk in the banking book appears to be on average the second most important factor considered by banks when determining economic capital (see IFRICRO, 2007). However, no unified economic capital model exists which integrates both risks in a consistent fashion. Therefore, regulators and banks generally analyse these risks independently from each other and derive total economic capital by some rule of thumb. Indeed, the most common rule arguably consists in simply “adding up”.
A serious shortcoming of this procedure is that it obviously fails to capture the interdependencies between these risks. For example, the literature has shown consistently that interest rates are a key driver of default frequencies, ie interest rates risk drives credit risk. And as we will show, credit risk also drives interest rate risk in the banking book. This raises several questions: What is the optimal level of economic capital if interdependencies are captured? How big is the mistake if economic capital is set against both risks independently and then just added to derive total economic capital? Are there any diversification benefits between both risk or do these risks compound each other in extreme circumstance?
To answer these questions we simulate an integrated credit and interest rate risk model, based on the framework developed by Drehmann, Stringa and Sorensen (2007) (henceforth DSS). This allows us to derive economic capital with and without accounting for the interdependencies mentioned above.
The dynamic interactions between credit and interest rate risk are relatively complex, but can be illustrated with a simple example. Consider a risk-neutral bank which fully funds an asset A with some liability L = A. Assume that A and L have a maturity of one year, and that L gets remunerated at the risk free rate r0.
Under risk neutrality, the interest rates charged on A is r0 plus a spread equal to the probability of default (PD) times the loss given default (LGD). Income received on assets minus income paid on liabilities is therefore equal to expected losses (EL=PD*LGD*A). If capital is set in the standard fashion only against credit risk, then capital indeed covers unexpected losses at the required confidence level.
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