An economic capital model integrating credit and interest rate risk in the banking book

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jbankfin.2009.06.012 Byline: Piergiorgio Alessandri (a), Mathias Drehmann (b) Keywords: Economic capital; Risk management; Credit risk; Interest rate risk; Asset and liability management Abstract: Banks often measure credit and interest rate risk in the banking book separately and then add the risk measures to determine economic capital. This approach misses complex interactions between the two risk types. We develop a framework where these risks are analysed jointly. Since banking book positions are generally not marked to market, our model is based on book value accounting. Our simulations show that interactions matter, and that ignoring them leads to risk overstatement. The magnitude of the errors depends on the structure of the balance sheet and on the repricing characteristics of assets and liabilities. Author Affiliation: (a) Bank of England, Threadneedle Street, London, EC2R 8AH, UK (b) Bank for International Settlements, Centralbahnplatz 2, 4002 Basel, Switzerland Article History: Received 12 March 2008; Accepted 16 June 2009