Liquidity risk, credit risk, market risk and bank capital

Abstract

PurposeThe 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/approachThe Basel II and the proposed Basel III capital requirements for banks' trading books, with a sample of bond portfolios, are implemented.FindingsThe 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/valueThe data, methodology and purpose are all original.