Integrating credit and interest rate risk: A theoretical framework and an application to banks' balance sheets

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 riskiness of a bank which is subject to correlated interest rate and credit risk. The framework accounts for all sources of credit risk, interest rate risk and their combined impact As we model the whole balance sheet of a bank the framework not only enables us to assess the impact of credit and interest rate risk 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 correlated interest rate and credit risk jointly on the whole portfolio of banks, including assets, liabilities and off-balance sheet itemsIntegration of credit risk & interest rate risk, asset & liability management of banks, economic value, stress testing