An Integrated Approach to Measuring Asset and Liability Risks in Financial Institutions

An Integrated Approach to Measuring Asset and Liability Risks in Financial Institutions

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Added in 2019 JUL | IME 2019 LIFE

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Risk measurement models for financial institutions typically focus on the net portfolio position and thus ignore distinctions between 1) assets and liabilities and 2) uncollateralized and collateralized liabilities. However, these distinctions are economically important. Liability risks affect the total amount of claims on the institution, while asset risks affect the amount available for claimants. Collateralization also affects the amounts recovered by different classes of claimants. We analyze a model of a financial institution with risky assets and liabilities, with potentially varying levels of collateralization across liabilities, showing that correct economic risk capital allocation requires complete segregation of asset, uncollateralized liability, and collateralized liability risks, with different risk measures for each. Our numerical analyses suggest that the conventional approach frequently yields over-investment in risky assets.

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