Long-term bank balance sheet management: Estimation and simulation of risk-factors

•We derive a single-period model for bank balance sheet management that illustrates the role of bank policy in credit risk.•We estimate long-term stochastic processes of mortgage rates, core funding rates, non-core funding rates, and charge-off rates.•We find that a vector auto-regressive model provides good fit of the risk factors over recent history.•We use simulations to show how the model can capture stylized aspects of historical risk trends.•We present a framework for assessing policy choices in long term management of assets and liabilities.

We propose a dynamic framework which encompasses the main risks in balance sheets of banks in an integrated fashion. Our contributions are fourfold: (1) solving a simple one-period model that describes the optimal bank policy under credit risk; (2) estimating the long-term stochastic processes underlying the risk factors in the balance sheet, taking into account the credit and interest rate cycles; (3) simulating several scenarios for interest rates and charge-offs; and (4) describing the equations that govern the evolution of the balance sheet in the long run. The models that we use address momentum and the interaction between different rates. Our results enable simulation of bank balance sheets over time given a bank's lending strategy and provides a basis for an optimization model to determine bank asset-liability management strategy endogenously.