Credit Spread Widening Risk and its Effects on Banks' Economic Capital

Abstract

Changes in value of a plain vanilla bond are largely due to the fluctuations of default-free yields (hereinafter referred to as risk-free rates) and to the dynamics of the credit spread required for protection against the borrower’s insolvency.

In most common financial asset evaluation techniques, credit spreads are considered as a risk-free rate increase, despite the use of “spread inclusive” discount factors induces to a slight distortion of the fair values and wrongly suggests that spread widening effects are quite similar to those produced by an equal increase in risk-free rates.

Previous literature has demonstrated that the value reactions to spread shifts are usually more pronounced than those observed in response to the term structure fluctuations. This phenomenon takes on macroscopic proportions for floating rate loans and yet remains largely ignored by value-at-risk models and by the most common asset-and-liability-management systems.

Even the Basel III framework, while highlighting the need to estimate the banking book’s value reaction to changes in interest rates leaves the effect of spread widening completely unexplored.

This attitude stems from the widespread and erroneous belief that modified duration can explain the price reaction of financial assets to fluctuations of risk-free rates as well as to spread widening and tightening.

If this were true, the effects of the general spread widening, observed between 2007 and 2009, would be easily offset by the similarly huge and general decline in risk-free rates, driven by the major central banks, in a short time interval. Evidently, this did not happen.

This paper analyses the hybrid nature of spread risk and separates the fundamental (intrinsic, or “credit”) and behavioural (extrinsic or “market”) components, to highlight how their occurrence would produce very different effects on the net value of the banking book.

It is therefore noted that the potential devaluation of assets, when related to the Credit-spread widening risk, is equal to the amount of unexpected losses and this offers a new conceptual framework which is very useful for assessing capital adequacy.

In the second part of this paper, it is observed that Market-spread fluctuations alter the value of bank assets and liabilities simultaneously and thus Market-spread risk can be easily managed by applying appropriate gap management methodologies, specifically addressed to reveal the mismatching of spread sensitivities.

Keywords: spread risk, option adjusted spread, asset and liability management, Basel, credit risk, credit pricing, financial crisis

JEL Classification: G14, G20, G21