Skip to main content

Advertisement

Log in

Rethinking economic capital management through the integrated derivative-based treatment of interest rate and credit risk

  • Analytical Models for Financial Modeling and Risk Management
  • Published:
Annals of Operations Research Aims and scope Submit manuscript

Abstract

This research revisits the economic capital management regarding banking books of financial institutions exposed to the emerging market sovereign debt. We develop a derivative-based integrated approach to quantify economic capital requirements for considered jointly interest rate and credit risk. Our framework represents a major contribution to the empirical aspects of capital management. The proposed innovative modeling allows applying standard historic value-at-risk techniques developed for stand-alone risk factors to evaluate aggregate impacts of several risks. We use the time-series of credit default swap spreads and interest rate swap rates as proxy measures for credit risk and interest rate risk, respectively. An elasticity of interest rate risk and credit risk, considered a function of the business cycle phases, maturity of instruments, creditworthiness, and other macroeconomic parameters, is gauged by means of numerical modeling. Our contribution to the new economic thinking regarding the interest rate risk and credit rate risk management consists in their integrated treatment as the dynamics of interest rate and credit spreads is found to demonstrate the features of automatic stabilizers of each other. This research sheds light on how financial institutions may address hedge strategies against downside risks. It is of special importance for emerging markets heavily dependent on foreign capital as it potentially allows emerging market banks to improve risk management practices in terms of capital adequacy and Basel III rules. From the regulatory perspective, by taking into account inter-risk diversification effects it allows enhancing financial stability through jointly optimizing Pillar 1 and Pillar 2 economic capital.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1
Fig. 2
Fig. 3
Fig. 4

Source Bloomberg, authors’ calculations

Similar content being viewed by others

Notes

  1. The minimum capital requirements for the credit risk (CR) are discussed in Section “Capital requirements for credit risk” of the Basel Accord, see pp. 72–189 of Regulation (EU) No 575/2013 (European Parliament 2013).

  2. As for interest rate risk (IRR) no minimum capital requirements is established under the Basel Accord, see “Interest rate in the banking book” document by Basel Committee on Banking Supervision (2016) for IRR-related standards.

References

  • Alexander, C. (2008). Value-at-risk models. London: Willey.

    Google Scholar 

  • Alessandri, P., & Drehmann, M. (2010). An economic capital model integrating credit and interest rate risk in the banking book. Journal of Banking and Finance, 34(4), 730–742.

    Article  Google Scholar 

  • Basel Committee on Banking Supervision (BCBS). (2011). Basel III: A global regulatory framework for more resilient banks and banking systems. http://www.bis.org/publ/bcbs189.pdf

  • Basel Committee on Banking Supervision (BCBS). (2016). Interest rate risk in the banking book. http://www.bis.org/bcbs/publ/d368.pdf

  • Boulkeroua, M., & Stark, A. (2013). On the determinants of the sensitivity of the yield spread of corporate bonds to changes in the level and slope of the yield curve. In N. Apergis (Ed.), Proceedings of the IV world finance conference (pp. 118–167).

  • Chen, R., Cheng, X., & Wu, L. (2013). Dynamic interactions between interest-rate and credit risk: Theory and evidence on the credit default swap term structure. Review of Finance, 17(1), 403–441.

    Article  Google Scholar 

  • Chen, R., Yang, L., Wang, W., & Tang, L. (2015). Discovering the impact of systemic and idiosyncratic risk factors on credit spread of corporate bond within the framework of intelligent knowledge management. Annals of Operations Research, 234, 3–15. doi:10.1007/s10479-014-1727-y.

    Article  Google Scholar 

  • European Parliament. (2013). Regulation (EU) No. 575/2013. http://www.eur-lex.europa.eu

  • FTSE International Limited. (2014). FTSE country classification process. http://www.ftse.com

  • Fuerst, F., McAllister, P., & Sivitanides, P. (2015). Flight to quality? An investigation of changing price spreads in commercial real estate markets. Studies in Economics and Finance, 32(1), 2–16.

    Article  Google Scholar 

  • Gubareva, M. (2014). Financial instability through the prism of flight-to-quality. Saarbrucken: Lambert Academic Publishing.

    Google Scholar 

  • Gubareva, M., & Borges, M. (2016a). Typology for flight-to-quality episodes and downside risk measurement. Applied Economics, 48(10), 835–853. doi:10.1080/00036846.2015.1088143.

    Article  Google Scholar 

  • Gubareva, M. & Borges, M. (2016b). Binary interest rate sensitivities of emerging market corporate bonds. In Z. Serrasqueiro, F. Sardo & J. Leitão (Eds.) Proceedings of the 9th Finance conference of the Portuguese finance network (PFN) (pp. 1685–1718). Covilha: Universidade da Beira Interior. ISBN: 978-989-654-300-6

  • International Monetary Fund. (2015). Global financial stability report, October 2015: Vulnerabilities, legacies, and policy challenges—risks rotating to emerging markets.

  • International Monetary Fund. (2016). Global financial stability report, April 2016: Potent policies for a successful normalization.

  • Jermann, U. & Yue, V. (2013). Interest rate swaps and corporate default. Working paper series No. 1590. European Central Bank.

  • Landschoot, A. (2008). Determinants of yield spread dynamics: Euro versus US dollar corporate bonds. Journal of Banking and Finance, 32(12), 2597–2605.

    Article  Google Scholar 

  • Lin, E., Sun, E., & Yu, M. (2016). Systemic risk, financial markets, and performance of financial institutions. \(S\).I.: Financial Economics. Annals of Operations Research, 1–25 doi:10.1007/s10479-016-2113-8.

  • Moody’s. (2015). Annual default study corporate default and recovery rates, 1920–2014. https://www.moodys.com/researchandratings.

  • Neal, R., Rolph, D., Dupoyet, B., & Jiang, X. (2015). Interest rates and credit spread dynamics. The Journal of Derivatives, 23(1), 25–39.

    Article  Google Scholar 

  • Standard & Poor’s. (2015). Default, transition, and recovery: 2014 Annual global corporate default study and rating transitions. http://www.standardandpoors.com/ratingsdirecty.

  • Tang, D. Y., & Yan, H. (2010). Market conditions, default risk and credit spreads. Journal of Banking and Finance, 34(4), 743–753.

    Article  Google Scholar 

  • Zimper, A. (2014). The minimal confidence level of Basel capital regulation. Journal of Banking Regulation, 15(2), 129–143.

    Article  Google Scholar 

Download references

Acknowledgements

Financial support by FCT (Fundação para a Ciência e a Tecnologia), Portugal is gratefully acknowledged. This article is part of the Strategic Project (UID/ECO/00436/2013).

Author information

Authors and Affiliations

Authors

Corresponding author

Correspondence to Mariya Gubareva.

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Gubareva, M., Borges, M.R. Rethinking economic capital management through the integrated derivative-based treatment of interest rate and credit risk. Ann Oper Res 266, 71–100 (2018). https://doi.org/10.1007/s10479-017-2438-y

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s10479-017-2438-y

Keywords

JEL Classification

Navigation