Dynamic modelling of shocks to credit spread risk in banking book: evidence from European sovereign markets

This research examines the relationship between credit spread risk in the banking book (CSRBB) and bond market behavior across various maturities in twelve European nations. We address the challenges banks encounter in modeling CSRBB in isolation, as directed by the European Banking Authority's (EBA) revised guidelines, which mandate the distinct management of CSRBB and interest rate risk in the banking book (IRRBB). Utilizing IRF and VAR models, the analysis demonstrates that credit spread shocks have divergent effects on sovereign bond I-Spreads and 5-year Credit Default Swap spreads across different tenors and countries. The results also indicate that shock absorption and transmission vary considerably between short-term and long-term bonds. Tenor sensitivity influences the structuring of risk-based capital, the development of hedging strategies, and the optimization of debt maturity. The findings question the validity of parallel shift assumptions in conventional CSRBB stress testing, indicating that term structure responses exhibit non-linearity, country dependence, and regime sensitivity. The study highlights the importance of translating IRF outputs into base, moderate, and severe shock scenarios for effective CSRBB modeling and compliance. This process allows financial institutions to improve risk mitigation strategies, ensure balance sheet resilience, and align with the EBA’s revised guidelines