The Basel Committee on Banking Supervision has issued a working paper that examines the interaction of market risk and credit risk, a relationship that has been redefined by the financial crisis, the BIS said Thursday.

The paper, which summarizes the findings of a BIS working group, notes that the distinction between market risk and credit risk has been blurred by the development of credit risk transfer markets and the move to mark-to-market accounting for a wide variety of financial instruments.

Historically, regulators may have treated these two risks as separate phenomena, but as the BIS says, “The financial crisis has illustrated how the two risks may reinforce each other and that in such stress situations illiquidity can exacerbate losses.”

“From a supervisory perspective, these developments raise important questions related to how the two types of risks can be defined and what relationships exist between them, how they should be aggregated and how precisely their joint risk is measured, what role liquidity plays in their interaction and under what conditions securitization — as one driver of the above developments — can work as a risk management approach,” it says.

The paper discusses the conceptual distinctions and empirical relationships between market risk and credit risk. It reviews issues related to aggregation and diversification benefits and discusses how market liquidity affects the relationship between the two sorts of risk. For example, it observes that, “Claims about the presence of diversification benefits between market and credit risk should be regarded with great caution if they are not derived from an integrated (‘bottom-up’) approach.”

IE