Derivative-based Treatment of Interest Rate Risk and Credit Risk for Economic Capital Management.

Capítulo de livro inserido na série Business Economics in a Rapidly-Changing WorldThis chapter addresses interest rate risk and credit risk assessment in banking books of financial institutions by the comprehensive method employing decade long historical data on derivative instruments such as interest rate swaps (IRS) and credit default swaps (CDS). The proposed method allows for integrated approach to interest rate and credit risk assessment as well as for measuring risks separately. To analyze the interrelation between interest rate and credit risk, IRS rates and CDS spreads are used as proxies for the interest rate risk and credit default risk related components in bonds yields. Then, the economic capital for banking book is modeled following individual and integrated approach to quantification of capital requirements for interest rate and credit risk. Capital-wise elasticity of interest rate risk and credit risk is assessed and analyzed through the prism of economic capital quantification for pre-crisis and post-crisis conditions. Economic capital for modeled fixed-income portfolio consisting of emerging market sovereign bonds is assessed. It is empirically demonstrated that such cross-risk elasticity is a function of the considered time windows and, hence, depends on the phases of business cycle; either expansion or contraction, as they affect risk-free interest rate level, creditworthiness of obligors, and other parameters which in their turn influence IRS rates and CDS spreads. Analyzing historical behavior of elasticity between interest rate and credit risk, potential hedge strategies against downside risk are proposed. They are based either on IRS or CDS contracts, or on a joint usage of both IRS and CDS instruments. Possible outcomes of such strategies from the point of view of economic capital optimization are discussed. Additionally, a comparison of the proposed derivative-based integrated approach with a bond yield-based historic VaR approach, widely employed in banking sector, is performed. The chapter discusses a regulatory perspective of interest rate and credit risk integration. Analyzing such risk integration results and focusing on diversification versus compounding effects this study represents a long needed attempt to define a common basis for discussion between banking industry and financial markets regulators. Examining rules for asset sensitivity or non-sensitivity to interest rate and providing an integrated treatment of interest rate and credit risk potentially allows for optimizing bank economic capital and unleashing resources for real economy. This research contributes to the discussion on the cross-geographies alignment of methodologies under Basel III capital accord. It potentially allows financial institution to improve their risk assessment and capital management.