Optimized economic capital for an emerging markets portfolio: Integrated approach to risk assessment

The main objective of this research is an assessment of interest rate risk and credit risk present in banking books of financial institutions. A derivative-based integrated approach to jointly quantify economic capital requirements for these two risks is developed following the historic value-at-risk method. It is based on the time series of credit default swap (CDS) spreads and interest rate swap (IRS) rates used as proxy measures for credit risk and interest rate risk, respectively.

The developed technique is applied to assess interest rate and credit risks jointly as well as to measure them on an individual basis. We also compare the outcomes of the proposed derivative-based integrated approach with a value-at-risk approach based on time series of bond yields, the methodology widely employed throughout the financial sector.

We apply our derivative based technique to modeling economic capital for fixed-income portfolios exposed to developing countries' debt. Based on the proposed approach, the cross elasticity of interest rate risk and credit risk is addressed through the prism of economic capital optimization. The employed historical data allow us to demonstrate that such cross-risk elasticity is a function of a business cycle phase, maturity of instruments, and creditworthiness of obligors.

Our contribution to the new economic thinking regarding interest rate risk and credit risk management is integrated treatment as the dynamics of interest rate and credit spread demonstrate the features of automatic stabilizers of each other. Such behavior does not represent an exceptional case but rather common and expectable circumstances, as crashes and recessions usually always coincide with a downward tendency in interest rate dynamics.

Thus, this research sheds light on how financial institutions may address hedge strategies against crystallization of downside risks. These strategies could be based on IRS contracts, CDS contracts, or on a combined employment of both IRS and CDS instruments. Possible outcomes of such strategies allow for optimizing economic capital allocated to banking books.

As developing countries are heavily affected by creditworthiness-related volatility of credit spreads, our approach using historical data for diverse geographies offer a clue for improving risk management practices in terms of capital adequacy and Basel III rules.

By taking into account inter-risks diversification effects, it allows enhancing financial stability through jointly optimizing Pillar 1 and Pillar 2 economic capital.