Interaction of Credit and Market Risks and Impact on Banks’ Economic Capital
DOI:
https://doi.org/10.14738/abr.113.14259Abstract
Banks often measure the magnitudes of credit and market risks separately, and then add up the two to estimate economic capital. This approach ignores the complex interactions between the two risk types. We develop a model in which these risks are estimated jointly. We used both Value at Risk (VaR) and Conditional Value at Risk (CoVaR) risk measures to analyze the relation between market and credit risks interconnectedness among banks during financial stress. Our model is based on the market returns and total provisions in 37 banks in Asia, Europe, and North America. The results show that deliberately ignoring the interaction between these types of risk leads to either an under or overestimation of the sum of the magnitudes of the two risks, and hence, results in an over or underestimation of economic capital. It was concluded that during times of financial distress, an increase in a bank’s provision would lead to an extreme loss in stock returns that were higher than the VaR value. This proves that underestimating credit risk can lead to an increase in the market risk faced by banks during financial distress.
References
Adrian, T. and Brunnermeier, M. (2011), CoVaR (No. w17454), National Bureau of Economic Research.
Alessandri, P. and Drehmann, M. (2010). An economic capital model integrating credit and interest rate risk in the banking book. Journal of Banking & Finance, 34(4), 730–742.
Barigozzi, M., & Brownlees, C. (2019). Nets: Network estimation for time series. Journal of Applied Econometrics , 34(3), 347-364.
Bellini, T. (2013). Integrated bank risk modeling: A bottom-up statistical framework. European Journal of Operational Research, 230(2), 385–398. https://doi.org/10.1016/j.ejor.2013.04.03
Betz, F., Hautsch, N., Peltonen, T. A., & Schienle, M. (2016). Systemic risk spillovers in the European banking and s overeign network. Journal of Financial Stability, 25, 206-224.
Bhattacharya, S. and Thakor, A. (1993). Contemporary banking theory. Journal of Financial Intermediation, 3(1), 2–50. https://doi.org/10.1006/jfin.1993.1001 Bloomberg. Terminal. Bloomberg 2021.
Breuer, T., Jandačka, M., Rheinberger, K., and Summer, M. (2010). Does adding up of economic capital for marketand credit risk amount to conservative risk assessment? Journal of Banking & Finance, 34(4), 703–712.
Brodeur, A., & Pergler, M. (2010). Top-down ERM: a pragmatic approach to managing risk from the C-suite. McKinsey Working Papers on Risk, Paper 22, McKinsey & Company, Washington, DC, USA.
Caballero, R. J., & Simsek, A. (2013). Fire sales in a model of complexity. The Journal of Finance, 68(6), 2549-2587 .
Duarte, F., & Eisenbach, T. M. (2015). Fire-sale spillovers and systemic risk. Staff Report no. 645.
Drehmann, M., Sorensen, S., and Stringa, M. (2010). The integrated impact of credit and interest rate risk on banks: A dynamic framework and stress testing application. Journal of Banking & Finance, 34(4), 713–729.
Freixas, X., Laeven, L., & Peydró , J. L. (2015). Systemic risk, crises and macroprudential policy.
Gai, P., Haldane, A., & Kapadia, S. (2011). Complexity, concentration, and contagion. Journal of Monetary Economi cs, 58(5), 453-470.
Girardi, G. and Tolga Ergün, A. (2013). Systemic risk measurement: Multivariate GARCH estimation of CoVaR. Journal of Banking & Finance, 37(8), 3169–3180. https://doi.org/10.1016/j.jbankfin.2013.02.027
Greenwood, R., Landier, A., & Thesmar, D. (2015). Vulnerable banks. Journal of Financial Economics, 115(3), 471-485.
Grundke, P. (2010). Top-down approaches for integrated risk management: How accurate are they? European Journal of Operational Research, 203(3), 662–672. https://doi.org/10.1016/j.ejor.2009.09.015
Hale, G., Kapan, T., & Minoiu, C. (2016, February). Crisis transmission through the global banking network. San Fr ancisco, CA, USA: Federal Reserve Bank of San Francisco.
Hansen, B. (1994). Autoregressive conditional density estimation. International Economic Review, 35(3), 705–730. https://www.jstor.org/stable/2527081
Hartmann, P. (2010). Interaction of market and credit risk. Journal of Banking & Finance, 34(4), 697–702.
Jarrow, R. and Turnbull, S. (2000). The intersection of market and credit risk. Journal of Banking & Finance, 24(1–2), 271–299. https://doi.org/10.1016/s0378-4266(99)00060-6
Joe, H., (1997), Multivariate Models and Multivariate Dependence Concepts. London: Chapman and Hall. http://dx.doi.org/10.1201/b13150
Joe, H., and Xu, J.J., (1996), The estimation method of inference functions for margins for multivariate models, Technical Report 166, Department of Statistics, University of British Columbia. https://doi.org/10.14288/1.0225985
Kritzman, M., Li, Y., Page, S., & Rigobon, R. (2011). Principal components as a measure of systemic risk. The Journ al of Portfolio Management, 37(4), 112-126.
Kretzschmar, G., McNeil, A., and Kirchner, A. (2010). Integrated models of capital adequacy– Why banks are undercapitalised. Journal of Banking & Finance, 34(12), 2838–2850.
Lucas, A., Schwaab, B., & Zhang, X. (2014). Conditional euro area sovereign default risk. Journal of Business & Eco nomic Statistics, 32(2), 271-284.
Mainik, G. and Schaanning, E. (2014). On dependence consistency of CoVaR and some other systemic risk measures. Statistics & Risk Modeling, 31(1), 49–77. https://doi.org/10.1515/strm-2013-1164
Nelson, D. (1991). Conditional heteroskedasticity in asset returns: A new approach. Econometrica, 59(2), 347–370. https://www.jstor.org/stable/2938260
Oh, D. and Patton, A. (2013). Simulated method of moments estimation for copula-based multivariate models. Journal of the American Statistical Association, 108(502), 689–700. https://doi.org/10.1080/01621459.2013.785952
Podlich, N., & Wedow, M. (2014). Crossborder financial contagion to Germany: How important are OTC dealers? I nternational Review of Financial Analysis, 33, 1-9.
Peydró, J. L., & Iyer, R. (2005). How Does a Shock Propagate? A Model of Contagion in the Interbank Market Due t o Financial Linkages. A Model of Contagion in the Interbank Market Due to Financial Linkages (May 2005).
Puzanova, N. and Düllmann, K. (2013). Systemic risk contributions: A credit portfolio approach. Journal of Banking & Finance, 37(4), 1243–1257. https://doi.org/10.1016/j.jbankfin.2012.11.017
Rodriguez, J. (2007). Measuring financial contagion: A copula approach. Journal of Empirical Finance, 14(3), 401–423. https://doi.org/10.1016/j.jempfin.2006.07.002
Tian, S., Yang, Y., & Zhang, G. (2013). Bank capital, interbank contagion, and bailout policy. Journal of Banking & F inance, 37(8), 2765-2778.
Tobias, A., and Brunnermeier, M. K. (2016). CoVaR. The American Economic Review, 106(7), 1705.
Sklar, A. (1959). Fonctions de répartition à n dimensions et leurs marges. Publications de l'Institut Statistique de l'Université de Paris, 8, 229–231.
Downloads
Published
How to Cite
Issue
Section
License
Copyright (c) 2023 Medhat Hassanein, Mohammed Bouaddi, Heba Mohamed Abdel Aziz
This work is licensed under a Creative Commons Attribution 4.0 International License.
