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AN ECONOMIC CAPITAL MODEL INTEGRATING CREDIT AND INTEREST RATE RISK IN THE BANKING BOOK

by Piergiorgio Alessandri and Mathias Drehmann

I think this is a version of a paper I have already referred either here or over in the asymptotix blogs. What is interesting is that this paper is in the European Central Bank working papers series. Are these ideas becoming finally mainstream? Would that not be just "the business". Instead of highlighting the abstract in a blog post, as I usually do, or the conclusions as I sometimes do, as my friends tell me "controversy is good!!", I am going to highlight below a little extract from the Literature Review, which opens this paper, published by the ECB overnight. Its the argument for mainstream which interests me now and I think should interest YOU, the dynamics and mechanics of the modelling are beautifully documented but YOU will not use them, unless you have the comfort of knowing that the ideas are not coming from some far away galaxy on the edge of the network, right?

The sort of opinion expressed behind the watercooler in the Credit Risk departments I advised pre-credit crunch and which pompous CROs (now departed) wrote to my bosses at SAP about me, pre-credit crunch. I think we are beginning to see the green shoots of "proper" techniques of risk capital quantification becoming mainstream at last, it has been a struggle, here is the quotation from the literature review section of this paper;-

"There is by now a large and well known literature on economic capital models for credit risk (for an overview see e.g. Gordy, 2000, or McNeil et al., 2005). These models are based on the idea that there is one or a set of common systematic risk factors which drive default rates of all exposures, but that conditional on a draw of systematic risk factors, defaults across exposures are independent. Various models then differ in the way they link default rates and systematic risk factors and whether they analytically solve for the loss distribution or simulate it.

Our approach to credit risk modelling follows this tradition. However, contrary to most models, we condition credit risk and the yield curve on a common set or systematic risk factors. Furthermore, we account for the loss in coupon payments if assets default.

In contrast to credit risk, no unified paradigm has yet emerged on how to best measure interest rate risk in the banking book (e.g. see Kuritzkes and Schuermann, 2007). The Basel Committee points to this as an important reason why interest rate risk in the banking book is not treated in a standardised fashion in the Basel II capital framework (see§762, Basel Committee, 2006). One of the simplest interest risk measures is gap analysis, where banks or regulators assess the impact of a parallel shift or twist in the yield curve by purely looking at the net repricing mismatch between assets, liabilities and off-balance sheet items. By now the literature has identified several problems with standard and more sophisticated gap analysis (e.g. see Staikouras, 2006).

Therefore, there has been a shift to more sophisticated methods based on either static or dynamic simulation approaches (see Basel Committee, 2004, 2008). Interest rate risk in the banking book can either be measured by earnings at risk or using an economic value approach. The latter measures the impact of interest rate shocks on the value of assets and liabilities (e.g. see OTS, 1999, or CEBS, 2006), whereas the former looks at the impact of the shocks on the cashflow generated by the portfolio (i.e. a bank’s net interest income). This paper follows the traditional earnings at risk approach which is heavily used in the industry and for regulatory purposes (see Basel Committee, 2008)."

The paper is here;

http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1041.pdf

by Piergiorgio Alessandri and Mathias Drehmann

I think this is a version of a paper I have already referred either here or over in the asymptotix blogs. What is interesting is that this paper is in the European Central Bank working papers series. Are these ideas becoming finally mainstream? Would that not be just "the business". Instead of highlighting the abstract in a blog post, as I usually do, or the conclusions as I sometimes do, as my friends tell me "controversy is good!!", I am going to highlight below a little extract from the Literature Review, which opens this paper, published by the ECB overnight. Its the argument for mainstream which interests me now and I think should interest YOU, the dynamics and mechanics of the modelling are beautifully documented but YOU will not use them, unless you have the comfort of knowing that the ideas are not coming from some far away galaxy on the edge of the network, right?

The sort of opinion expressed behind the watercooler in the Credit Risk departments I advised pre-credit crunch and which pompous CROs (now departed) wrote to my bosses at SAP about me, pre-credit crunch. I think we are beginning to see the green shoots of "proper" techniques of risk capital quantification becoming mainstream at last, it has been a struggle, here is the quotation from the literature review section of this paper;-

"There is by now a large and well known literature on economic capital models for credit risk (for an overview see e.g. Gordy, 2000, or McNeil et al., 2005). These models are based on the idea that there is one or a set of common systematic risk factors which drive default rates of all exposures, but that conditional on a draw of systematic risk factors, defaults across exposures are independent. Various models then differ in the way they link default rates and systematic risk factors and whether they analytically solve for the loss distribution or simulate it.

Our approach to credit risk modelling follows this tradition. However, contrary to most models, we condition credit risk and the yield curve on a common set or systematic risk factors. Furthermore, we account for the loss in coupon payments if assets default.

In contrast to credit risk, no unified paradigm has yet emerged on how to best measure interest rate risk in the banking book (e.g. see Kuritzkes and Schuermann, 2007). The Basel Committee points to this as an important reason why interest rate risk in the banking book is not treated in a standardised fashion in the Basel II capital framework (see§762, Basel Committee, 2006). One of the simplest interest risk measures is gap analysis, where banks or regulators assess the impact of a parallel shift or twist in the yield curve by purely looking at the net repricing mismatch between assets, liabilities and off-balance sheet items. By now the literature has identified several problems with standard and more sophisticated gap analysis (e.g. see Staikouras, 2006).

Therefore, there has been a shift to more sophisticated methods based on either static or dynamic simulation approaches (see Basel Committee, 2004, 2008). Interest rate risk in the banking book can either be measured by earnings at risk or using an economic value approach. The latter measures the impact of interest rate shocks on the value of assets and liabilities (e.g. see OTS, 1999, or CEBS, 2006), whereas the former looks at the impact of the shocks on the cashflow generated by the portfolio (i.e. a bank’s net interest income). This paper follows the traditional earnings at risk approach which is heavily used in the industry and for regulatory purposes (see Basel Committee, 2008)."

The paper is here;

http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1041.pdf

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