The Integrated Impact of Credit and Interest Rate Risk on Banks: An Economic Value and Capital Adequacy Perspective

40 Pages Posted: 2 Mar 2007

See all articles by Mathias Drehmann

Mathias Drehmann

Bank for International Settlements (BIS)

Steffen Sorensen

Moody's Investor Services

Marco Stringa

Bank of England

Date Written: January 2008

Abstract

Credit and interest rate risk in the banking book are the two most important risks faced by commercial banks. In this paper we derive a consistent and general framework to measure the integrated impact of both risks on banks' portfolios. The framework accounts for all sources of credit risk and interest rate risk. By modeling the whole portfolio of a bank and by taking account of the repricing characteristics of all exposures, we can assess the impact of credit and interest rate risk not only on the bank's economic value but also on its future earnings and capital adequacy. We apply our framework to a hypothetical bank in normal and stressed conditions. The simulation highlights that it is fundamental to measure the impact of interest rate and credit risk jointly. We also show that it is crucial to model the whole portfolio, including the repricing and maturity characteristics of assets, liabilities and off balance sheet items.

Keywords: Integration of credit risk and interest rate risk, asset and liability management of banks, economic value, stress testing

JEL Classification: G21, E47, C13

Suggested Citation

Drehmann, Mathias and Sorensen, Steffen and Stringa, Marco, The Integrated Impact of Credit and Interest Rate Risk on Banks: An Economic Value and Capital Adequacy Perspective (January 2008). Bank of England Working Paper No. 339. Available at SSRN: https://ssrn.com/abstract=966270 or http://dx.doi.org/10.2139/ssrn.966270

Mathias Drehmann (Contact Author)

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

Steffen Sorensen

Moody's Investor Services

New York, NY 10007
United States

Marco Stringa

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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