Bank Balance Sheet Risk Allocation

32 Pages Posted: 8 Jan 2020

See all articles by Pedro Júdice

Pedro Júdice

Montepio Bank; Business Research Unit, Instituto Superior de Ciencias do Trabalho e da Empresa (ISCTE)

Qiji Jim Zhu

Western Michigan University

Date Written: December 13, 2019

Abstract

We formulate the optimal balance sheet management problem as a linear program and study it using a duality approach. In addition to helping to determine the optimal balance sheet, the dual problem also provides us the market prices of interest rate risk and credit risk. Our methodology is used to determine premia on credit risk and interest rate risk for commercial banks, which in turn allows us to manage the risk allocation for a bank given a risk budget. Moreover, our approach will be of interest to regulators, who can use it to assess the market price of credit and interest rate risk at each point in the economic cycle. Finally, we apply this methodology to real data and show how it can be used to a real setting, using diversification constraints and a greedy algorithm that results in the optimal asset-liability allocation.

Keywords: Interest rate risk, credit risk, balance sheet optimization, risk allocation, duality.

JEL Classification: C02, G21

Suggested Citation

Júdice, Pedro and Zhu, Qiji Jim, Bank Balance Sheet Risk Allocation (December 13, 2019). Available at SSRN: https://ssrn.com/abstract=3505419 or http://dx.doi.org/10.2139/ssrn.3505419

Pedro Júdice (Contact Author)

Montepio Bank ( email )

Rua do Carmo, No. 42, 6.andar
Lisbon, 1200-094
Portugal

Business Research Unit, Instituto Superior de Ciencias do Trabalho e da Empresa (ISCTE) ( email )

Complexo Indeg/Iscte
Av. Professor Anibal Bettencourt
Lisboa, 1600-189
Portugal

Qiji Jim Zhu

Western Michigan University ( email )

Kalamazoo, MI 49008
United States

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