An Economic Capital Model Integrating Credit and Interest Rate Risk in the Banking Book

Abstract

Banks typically determine their capital levels by separately analysing credit and interest rate risk, but the interaction between the two is significant and potentially complex. We develop an integrated economic capital model for a banking book where all exposures are held to maturity. Our simulations show that capital is mismeasured if risk interdependencies are ignored: adding up economic capital against credit and interest rate risk derived separately provides an upper bound relative to the integrated capital level. The magnitude of the difference depends on the structure of the balance sheet and on the repricing characteristics of assets and liabilities.

Keywords: Economic capital, risk management, credit risk, interest rate risk, asset and liability management

JEL Classification: G21, E47, C13, M41