Bank Balance Sheet Risk Allocation
32 Pages Posted: 8 Jan 2020
Date Written: December 13, 2019
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: Suggested Citation