Bank balance sheet risk allocation

Abstract We formulate the optimal balance sheet management problem as a linear program and study it using a duality approach. In addition to helping determine the optimal balance sheet, the dual problem also provides us the interest rate risk and credit risk pricing. We deploy our methodology to determine premia on credit risk and interest rate risk for commercial banks, which allows us to manage the risk allocation for a bank given a risk budget. Moreover, our approach will be of interest to regulators, who can use it to assess the price of credit and interest rate risk at each point in the economic cycle. Finally, we apply this methodology to real data and show how it can be used in a real-world setting, using diversification constraints and a greedy algorithm that results in the optimal asset-liability allocation.