Liquidity risk, credit risk, market risk and bank capital

Simone Varotto

doi:10.1108/17439131111122139

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International Journal of Managerial Finance

ISSN: 1743-9132

Online from: 2005

Subject Area: Accounting and Finance

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Liquidity risk, credit risk, market risk and bank capital

Document Information:
Title:	Liquidity risk, credit risk, market risk and bank capital
Author(s):	Simone Varotto, (ICMA Centre – Henley Business School, University of Reading, Reading, UK)
Citation:	Simone Varotto, (2011) "Liquidity risk, credit risk, market risk and bank capital", International Journal of Managerial Finance, Vol. 7 Iss: 2, pp.134 - 152
Keywords:	Capital markets, Credit, Financial risk, Liquidity, Risk management
Article type:	Research paper
DOI:	10.1108/17439131111122139 (Permanent URL)
Publisher:	Emerald Group Publishing Limited
Acknowledgements:	JEL Classification – G11, G21, G22, G28, G32. The author would like to thank Carol Alexander, Chris Brooks, Harvey Rosenblum, Silvia Stanescu and Charles Ward for helpful comments, as well as participants at the 2010 Western Economic Association International and International Banking, Economics and Finance Association for their feedback on previous versions of the paper. Needless to say, all errors and omissions are the author's own.
Abstract:	Purpose – The purpose of this paper is to investigate the relationship between liquidity and credit risk, and employ the findings to estimate the Incremental Risk Charge (IRC), the new credit risk capital add-on introduced by the Basel Committee for banks' trading books. The IRC estimates are compared with stressed market risk measures, derived from a sample of corporate bond indices encompassing the recent financial crisis. This can determine the extent to which trading book capital would change in stress conditions, under newly proposed rules. Design/methodology/approach – The Basel II and the proposed Basel III capital requirements for banks' trading books, with a sample of bond portfolios, are implemented. Findings – The findings show that, although the (incremental) credit risk in the trading book may be considerable, the capital needed to absorb market risk-related losses in stressed scenarios can be more than ten times larger. Originality/value – The data, methodology and purpose are all original.