Adverse risk interaction: An integrated approach

•We study adverse interaction between credit and market risk.•We develop a model in which risk is driven by both macroeconomic and market factors.•We illustrate the model via numerical simulations using data from Serbia.•The total VaR is higher than the simple sum of credit and market VaR.•The adverse interaction effect increases with VaR confidence level.

This paper studies adverse interaction between credit and market risk. We develop a comprehensive Merton-type model, in which payment ability of borrowers is driven by the overall economic growth, while the level of their liabilities is sensitive to market variables. To illustrate the model, we apply numerical simulations to estimate credit, market and integrated Value at Risk from the loss distribution using industry-wide data from the Serbian banking sector. We show that-even after accounting for presence of market risk in the banking book-the total risk remains higher than the simple sum of credit and market risk. The results emphasize the importance of integrated approach to assessment of economic capital.